SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
Release No. 34-38672; International Series Release No. IS-1085; File No.
S7-16-97
Regulation of Exchanges
AGENCY: Securities and Exchange Commission.
ACTION: Concept Release.
SUMMARY: The Securities and Exchange Commission ("SEC" or "Commission") is
reevaluating its approach to the regulation of exchanges and other markets
in light of technological advances and the corresponding growth of
alternative trading systems and cross-border trading opportunities.
Accordingly, the Commission is soliciting comment on a broad range of
questions concerning the oversight of alternative trading systems, national
securities exchanges, foreign market activities in the United States, and
other related issues. Following receipt of public comment, the Commission
will determine whether rulemaking is appropriate.
DATES: Comments must be received on or before [insert date 90 days after
date of publication in the Federal Register].
ADDRESSES: Interested persons should submit three copies of their written
data, views, and opinions to Jonathan G. Katz, Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Comments may also be submitted electronically at the following e-mail
address: rule-comments@sec.gov. All comment letters should refer to File
No. S7-16-97; this file number should be included on the subject line if
comments are submitted using e-mail. All submissions will be available for
public inspection and copying at the Commission's Public Reference Room,
Room 1024, 450 Fifth Street, N.W., Washington D.C. 20549. Electronically
submitted comment letters will be posted on the Commission's Internet web
site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: For questions or comments regarding this
release, contact: Kristen N. Geyer, Special Counsel, at (202) 942-0799;
Gautam S. Gujral, Special Counsel, at (202) 942-0175; Marie D'Aguanno Ito,
Special Counsel, at (202) 942-4147; Paula R. Jenson, Deputy Chief Counsel,
at (202) 942-0073; or Elizabeth K. King, Special Counsel, at (202) 942-
0140, Division of Market Regulation, Securities and Exchange Commission,
Mail Stop 5-1, 450 Fifth Street, N.W., Washington, D.C. 20549. For
questions or comments regarding corporate disclosure and securities
registration issues raised in this release, contact David Sirignano,
Associate Director, at (202) 942-2870, Division of Corporation Finance,
Securities and Exchange Commission, Mail Stop 3-1, 450 Fifth Street, N.W.,
Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Purpose of Concept Release
B Alternatives for Revising Domestic Market Regulation
C. Alternatives for Revising Regulation Applicable to
Foreign Market Activities in the United States
D. Conclusion
II. Regulation of Domestic Markets
A. Technological Advances
B. Market Regulation
1. The Current Regulatory Approach Applies
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Inappropriate Regulation to Alternative Trading
Systems
2. The Current Regulatory Approach Impedes
Effective Regulation
a. Market Access and Fairness
b. Market Transparency and Coordination
c. Market Surveillance
d. Market Stability and Systemic Risks
C. Conclusion
III. Approaches to Market Oversight
A. Regulatory Structure
B. Regulatory Tools
IV. Proposals Under Consideration to Integrate Alternative Trading
Systems into the Existing Regulatory Structure for Market
Oversight
A. Integrating Alternative Trading Systems into the
National Market System Through Broker-Dealer
Regulation
1. Fully Integrating the Orders of All Market Participants
into the Public Quotation System and Facilitating
Public Access to Such Orders
2. Improving the Surveillance of Trading
Conducted on Alternative Trading Systems
3. Ensuring Adequate Capacity of Alternative
Trading Systems
4. Potential Problems with Regulating Alternative
======END OF PAGE 3======
Trading Systems Under the Broker-Dealer Regulatory
Scheme
a. Alternative Trading Systems Would Not Be
Subject to Requirements Designed to
Assure Fair Treatment of Investors
b. Broker-Dealers that Operate Alternative
Trading Systems Will Still Be Required to
Comply with Potentially Inapplicable
Regulation and Be Subject to Oversight by
SROs
c. Alternative Trading Systems Will Be Free
to Engage in Anticompetitive Activities
5. Conclusion
B. Integrating Alternative Trading Systems into
Market Regulation Through Exchange Regulation
1. Creating a New Category Called "Exempted
Exchanges" for Smaller and Passive Alternative
Trading Systems
a. Low Impact Markets
b. Passive Markets
c. Requirements for Exempted Exchanges
2. The Application of Exchange Regulation to
Alternative Trading Systems That Are Not Exempted
Exchanges
a. Using the Commission's Exemptive
Authority to Encourage Innovation and to
======END OF PAGE 4======
Eliminate Barriers to Non-Traditional
Exchanges
(i) The Commission Could Consider Permitting
Institutional Access to Exchanges
(ii) The Commission Could Consider Ways in
Which Alternative Exchanges Can Meet
Fair Representation Requirements
3. Expanding the Commission's Interpretation of "Exchange"
a. Effects of Expanding the Commission's
Interpretation of "Exchange" on Selected
Types of Alternative Trading Systems
(i) Broker-Dealer Activities
(ii) Organized Dealer Markets
(iii) Information Vendors and Bulletin Boards
(iv) Interdealer Brokers
4. Effect of Broadening the Definition of
"Exchange"
a. Regulation of Securities Trading on
Alternative Trading Systems
b. Integration with National Market System
Mechanisms and Existing Exchange Practices
(i) Inter-Market Plans
(A) Quotation and Transacting Reporting
(B) Intermarket Trading System
(ii) Uniform Trading Standards
c. Oversight of Non-Broker-Dealers That
======END OF PAGE 5======
Have Access to Exchanges and Clearance
and Settlement of Non-Broker-Dealer
Trades
d. Application of Broker-Dealer Regulation
to Certain Exchanges
C. Conclusion
V. The Commission Could Consider Ways in Which Requirements Might Be
Reduced or Expedited for Registered Exchanges
A. Ways to Further Expedite Rule Filings
B. Surveillance and Enforcement
VI. Costs and Benefits of Revising the Regulation of Domestic Markets
VII. Regulation of Foreign Market Activities in the United States
A. The Need for A Clear Regulatory Structure to
Address U.S. Investors' Electronic Cross-Border
Trading
1. The Applicability of the U.S. Regulatory
Structure to the Activities of Access
Providers Has Not Been Expressly Addressed
2. U.S. Investors' Ability to Trade Directly on a
Foreign Market And Investor Protection Concerns
Under the Federal Securities Laws
B. Regulating Foreign Market Activities in the United
States
1. Sole Reliance on Foreign Markets' Home Country
Regulation
======END OF PAGE 6======
2. Requiring Foreign Markets to Register as
National Securities Exchanges
3. Regulating Access Providers to Foreign Markets
a. Access Providers to U.S. Members of
Foreign Markets
b. Broker-Dealer Access Providers
c. Requirements Applicable to Access Providers
(i) Conditions Relating to the Type of Foreign
Market
(ii) Conditions Relating to Type of
Persons and Securities
(iii)Recordkeeping, Reporting, Disclosure,
and Antifraud Requirements
C. Addressing the Differences Between U.S. and
Foreign Markets' Listed Company Disclosure
Standards
D. Costs and Benefits of Revising Regulation of
Foreign Market Activities in the United States
E. Conclusion
VIII. Summary of Requests for Comment
I. Executive Summary
A. Purpose of Concept Release
Stock markets play a critical role in the economic life of the United
States. The phenomenal growth of the U.S. markets over the past 60 years
is a direct result of investor confidence in those markets. Technological
trends over the past two decades have also contributed greatly to this
======END OF PAGE 7======
success. In particular, technology has provided a vastly greater number of
investment and execution choices, increased market efficiency, and reduced
trading costs. These developments have enhanced the ability of U.S.
exchanges to implement efficient market linkages and advanced the goals of
the national market system ("NMS").
At the same time, however, technological changes have posed
significant challenges for the existing regulatory framework, which is ill-
equipped to respond to innovations in U.S. and cross-border trading.
Specifically, two key developments highlight the need for a more forward-
looking, flexible regulatory framework: (1) the exponential growth of
trading systems that present comparable alternatives to traditional
exchange trading; and (2) the development of automated mechanisms that
facilitate access to foreign markets from the United States.
The Commission estimates that alternative trading systems
currently handle almost 20 percent of the orders in over-the-
Trading systems not registered as exchanges have
been referred to in previous Commission releases
as "proprietary trading systems," "broker-dealer
trading systems," and "electronic communications
networks." The latter two terms are defined in
Rules 17a-23 and 11Ac1-1 under the Securities
Exchange Act of 1934 ("Exchange Act"), 17 CFR
240.17a-23 and 240.11Ac1-1, respectively. The
term "alternative trading systems" will be used
throughout this release to refer generally to
automated systems that centralize, display, match,
cross, or otherwise execute trading interest, but
that are not currently registered with the
Commission as national securities exchanges or
operated by a registered securities association.
For purposes of this release, the term "order"
generally means any firm trading interest,
including both limit orders and market maker
quotations.
======END OF PAGE 8======
counter ("OTC") stocks and almost 4 percent of orders in securities listed
on the New York Stock Exchange ("NYSE"). The explosive growth of
alternative trading systems over the past several years has significant
implications for public secondary market regulation. Even though many of
these systems provide essentially the same services as traditional markets,
most alternative trading systems are regulated as broker-dealers. As a
result, they have been subject to regulations designed primarily to address
traditional brokerage, rather than market, activities. For example, these
systems are typically subject to oversight by self-regulatory organizations
("SROs") that themselves operate exchanges or quotation systems, which
raises inherent competitive concerns.
At the same time, alternative trading systems are not fully integrated
into the national market system. As a result, activity on alternative
trading systems is not fully disclosed to, or accessible by, public
investors. The trading activity on these systems may not be adequately
surveilled for market manipulation and fraud. Moreover, these trading
systems have no obligation to provide investors a fair opportunity to
participate in their systems or to treat their participants fairly, nor do
they have an obligation to ensure that they have sufficient capacity to
handle trading demand. These concerns together with the increasingly
important role of alternative trading systems, call into question the
fairness of current regulatory requirements, the effectiveness of existing
NMS mechanisms, and the quality of public secondary markets.
The impact of technological change has not been limited to domestic
markets. Foreign markets, information vendors, and broker-dealers have
developed automated systems that enable U.S. persons to trade directly on
======END OF PAGE 9======
foreign markets from the United States. The Commission to date has not
addressed the regulatory status of entities that limit their activities to
providing U.S. investors access to foreign markets. As a result, many
foreign markets have been reluctant to provide these services directly to
U.S. investors. This has highlighted the need to establish standards that
can accommodate U.S. investors' growing interest in cross-border trading,
and better ensure that this type of cross-border trading is subject to
appropriate safeguards. At the same time, improved foreign market access
would mean that U.S. investors can trade securities of companies listed
solely on foreign markets as easily as securities of companies that satisfy
the Commission's disclosure and reporting requirements. This would raise
additional questions as to how to craft a regulatory scheme that provides
sufficient information to investors about the securities they trade.
These and other questions raised by the application of the existing
regulatory approach to technologically changing markets are only likely to
multiply as technology facilitates ways of trading and enables the creation
of market structures that were unimaginable a few years ago. In light of
these issues, the Commission is now reevaluating its regulation of the
markets, particularly its oversight of alternative trading systems,
registered exchanges, and foreign market activities in the United States.
In doing so, the Commission seeks to develop a forward-looking and enduring
approach that will permit diverse markets to evolve and compete, while
preserving market-wide transparency, fairness, and integrity. The issues
raised by technology in the domestic markets are summarized in Part B below
and discussed in greater detail in Sections II through VI. The issues
raised by technology in the foreign markets are summarized in Part C below
======END OF PAGE 10======
and discussed in greater detail in Section VII of this release.
B. Alternatives for Revising Domestic Market Regulation
The questions raised by technological developments in the U.S. markets
could be addressed in a variety of ways. As an initial matter, the
Commission is soliciting comment on whether the current statutory and
regulatory framework remains appropriate in light of the myriad new means
of trading securities made possible by emerging and evolving technologies.
The Commission is also soliciting comment on alternative ways of addressing
these issues within the existing securities law framework. The release
discusses two alternatives in particular that would integrate alternative
trading systems more fully into mechanisms that promote market-wide
transparency, investor protection, and fairness.
First, the Commission could continue to regulate alternative trading
systems as broker-dealers and develop rules applicable to these systems,
and their supervising SROs that would more actively integrate these systems
into NMS mechanisms. The Commission could, for example, require
alternative trading systems to provide additional audit trail information
to SROs, to assist SROs in their surveillance functions, and to adopt
standard procedures for ensuring adequate system capacity and the integrity
of their system operations. The Commission could then require SROs to
integrate trading on alternative trading systems into their ongoing, real-
time surveillance for market manipulation and fraud, and to develop
surveillance and examination procedures specifically targeted to
alternative trading systems they supervise. In addition, the Commission
could require alternative trading systems to make all orders in their
systems available to their supervising SROs, and require such SROs to
======END OF PAGE 11======
incorporate those orders into the public quotation system. The Commission
could also require that alternative trading systems provide the public with
access to these orders on a substantially equivalent basis as provided to
system participants.
Alternatively, the Commission could integrate alternative trading
systems into the national market system as securities exchanges, by
adopting a tiered approach to exchange regulation. The first tier, under
this type of approach, could consist of the majority of alternative trading
systems, those that have limited volume or do not establish trading prices,
which could be exempt from traditional exchange requirements. For example,
exempt exchanges could be required to file an application and system
description with the Commission, report trades, maintain an audit trail,
develop systems capacity and other operational standards, and cooperate
with SROs that inspect their regulated participants. Most alternative
trading systems currently regulated as broker-dealers would be exempt
exchanges.
The second tier of exchanges under this approach could consist of
alternative trading systems that resemble traditional exchanges because of
their significant volume of trading and active price discovery. These
systems could be regulated as national securities exchanges. The
Commission could then use its exemptive authority to eliminate barriers
that would make it difficult for these non-traditional markets to register
as exchanges, by exempting such systems from any exchange registration
requirements that are not appropriate or necessary in light of their
business structure or other characteristics. For example, the Commission
could exempt alternative trading systems that register as exchanges from
======END OF PAGE 12======
requirements that exchanges have a traditional membership structure, and
from requirements that limit exchange participation to registered broker-
dealers. The Commission could also use its exemptive authority to reduce
or eliminate those exchange requirements that are incompatible with the
operation of for-profit, non-membership alternative trading systems.
This approach could integrate these alternative trading systems more
fully into NMS mechanisms and the plans governing those systems,
potentially by requiring these systems to become members of those
plans. Because alternative trading systems differ in several key
respects from currently registered exchanges, this could require revision
of those plans in order to accommodate diverse and evolving trading
systems.
Finally, a third tier of exchanges, consisting of traditional
membership exchanges, could continue to be regulated as national securities
exchanges. The Commission could then use its exemptive authority to reduce
overall exchange requirements. In this regard, the Commission is
considering ways to reduce unnecessary regulatory requirements that make it
difficult for currently registered exchanges to remain competitive in a
changing business environment. The Commission, for example, could further
accelerate rule filing and approval procedures for national securities
exchanges and securities associations, and allow fully automated exchanges
to meet their regulatory requirements in non-traditional ways.
One way for the Commission to implement this tiered approach would be
to expand its interpretation of the definition of "exchange." For example,
the Commission could reinterpret the term "exchange" to include any
See infra notes 162 to 175 and accompanying text.
======END OF PAGE 13======
organization that both: (1) consolidates orders of multiple parties; and
(2) provides a facility through which, or sets material conditions under
which, participants entering such orders may agree to the terms of a trade.
C. Alternatives for Revising Regulation Applicable to Foreign Market
Activities in the United States
The questions raised by the activities of foreign markets in the
United States could also be addressed in a number of ways. As an initial
matter, any proposal should address questions about the lack of comparable
information about securities of non-reporting foreign companies. In
addition, any approach to regulating access to foreign markets from the
U.S. should address the issue of whether sufficient information is
disclosed to U.S. investors regarding the risks of trading on foreign
markets and whether the Commission has the ability to enforce the antifraud
provisions of the U.S. securities laws.
This release describes a number of different ideas for addressing
foreign market activity in the United States, including applying
traditional exchange regulation to foreign markets that seek to enter the
United States. At the other extreme, the Commission could rely solely on
home country regulation of the foreign market. Alternatively, the
Commission could take an intermediate approach by establishing regulatory
requirements for entities that provide U.S. persons with direct access to
foreign markets ("access providers"), regardless of whether the entity is
the foreign market itself, a broker-dealer, or another service provider.
Such access providers could be required to comply with limited
recordkeeping, reporting, and disclosure requirements, as well as the
======END OF PAGE 14======
antifraud provisions of the federal securities laws.
Under this type of approach, an access provider that provides a U.S.
member of a foreign market with direct access to that foreign market's
trading facilities would register as a securities information processor
("SIP") under Section 11A of the Exchange Act. Foreign markets,
information vendors, and other access providers could be required to
register as SIPs, or to conduct their U.S. activities through another
registered SIP. As a condition of registration, SIPs could also be limited
to trading foreign securities that are registered with the Commission under
the Exchange Act or limited to dealing with sophisticated parties.
Broker-dealers that act as access providers could be required to
comply with the same, limited recordkeeping, reporting, disclosure, and
antifraud requirements as SIPs. The Commission could also permit broker-
dealer access providers to provide both retail and sophisticated investors
with electronic links to foreign markets, and to provide such links to
foreign markets that trade U.S. and foreign securities, regardless of
whether those securities are registered with the Commission. This approach
might provide adequate protections to U.S. investors trading on foreign
markets, while facilitating greater transparency.
In creating an appropriate regulatory scheme to address U.S. investor
access to unregistered foreign securities, the Commission seeks to balance
the desire to craft a forward-looking and enduring approach to the
oversight of the securities markets with concerns that U.S. investors have
access to full and complete disclosure about the securities they trade.
The Commission has been working directly with fellow regulators around the
world on a variety of initiatives to improve the efficiency of cross-border
======END OF PAGE 15======
capital flows.
D. Conclusion
Regulation should not be static. Changes in the markets should be
accompanied by corresponding changes in market regulation. In light of the
rapid pace of technological advancements during the past two decades, it is
critical to develop a regulatory framework that both accommodates
traditional market structures and provides sufficient flexibility to ensure
that markets of the future promote fairness, efficiency, and transparency.
The purpose of this release is to facilitate a dialogue as to how this can
best be achieved.
II. Regulation of Domestic Markets
A. Technological Advances
Securities markets serve several basic functions that are critical to
facilitating investment and, as a result, materially influence the long-
term financial security of a large segment of the population.
For example, markets provide the forum for individuals to invest in
securities and for financial instruments to be readily converted into cash
when needed. Securities markets also serve as a fundamental indicator of
national and international economic health, in part because they reveal
investors' judgments about the potential earning capacity of
corporations. They help to raise and efficiently allocate
See generally SEC, Report of the Special Study of
the Securities Markets of the Securities and
Exchange Commission, H.R. Doc. No. 95, 88th Cong.,
1st Sess. Pt. 1, at 9 (1963) (hereinafter Special
Study).
Essentially, securities markets centralize
information about buying and selling interest,
(continued...)
======END OF PAGE 16======
capital by providing a reliable means of valuing assets and facilitating
the flow of capital into private enterprise. They also allocate capital
toward productive uses by providing a forum where stocks can compete for
investment dollars. U.S. securities markets have been highly
successful at fulfilling these functions and are consistently the world's
largest, most liquid, efficient, and fair. Moreover, U.S.
(...continued)
either by physically or electronically
centralizing order interaction, or by centralizing
quote and trading information. Because of this
interaction of supply and demand, a stock price is
considered by many to be the best estimate by
investors of the present value of a company's
future earnings. As a result of such beliefs,
stock prices influence investment calculations,
the allocation of resources, company business
decisions, and economic planning. See 2 Thomas
Lee Hazen, Treatise on the Law of Securities
Regulation, 10.1, at 4 (3d ed. 1995); U.S.
Congress, Office of Technology Assessment, Pub.
No. OTA-CIT-469, Electronic Bulls & Bears: U.S.
Securities Markets & Information Technology at 3,
26 (1990) (hereinafter Electronic Bulls & Bears).
See generally Jack Clark Francis, Investment
Analysis and Management 57, 196-97 (4th ed. 1986).
See generally Electronic Bulls & Bears, supra note
5, at ch. 2; Francis, supra note 5, at 57.
As of December 31, 1996, there were 3,530
securities trading on the NYSE, representing 2907
NYSE-listed companies. Market Records Shattered
in 1996, The Exchange (NYSE), Jan./Feb. 1997, at
1-2. In addition, as of December 31, 1996, the
Nasdaq Stock Market ("Nasdaq") listed over 6300
stocks of 5556 companies, and dollar volume on
that market has grown to almost equal that of the
NYSE. Conversation with staff of Corporate
Communications, National Association of Securities
Dealers, Inc. ("NASD") (Feb. 21, 1997). In 1996,
the average daily share volume on Nasdaq was
543,839,000 shares and the total dollar volume was
$3,301.8 billion. During that same period, the
NYSE's average daily share volume was 409,893,000
(continued...)
======END OF PAGE 17======
markets have continued to attract foreign listings and investors even as
other markets become more competitive. This success has come
about, in part, because the strength and stability of U.S. markets have
allowed people throughout the world to feel confident investing a large
percentage of their personal wealth in the future of companies trading on
those markets.
The ability of U.S. markets to use technology to increase efficiency,
reduce the costs of trading, and respond to changing investor demands has
also contributed significantly to the success of our markets. Over the
past three decades, technology has transformed U.S. markets. Investors,
particularly the growing institutional investor base, now have numerous
alternatives to traditional exchange trading and the OTC market.
Similarly, market participants (including broker-dealers, issuers, and
service providers) have integrated technological advancements into their
trading and marketing activities. For example, some broker-
(...continued)
shares and its total dollar volume was $4,063.7
billion. See Market Records Shattered in 1996,
The Exchange (NYSE), Jan./Feb. 1997, at 1-2.
Both the NYSE and Nasdaq have experienced
significant growth in foreign company listings.
Foreign company listings on the NYSE increased
from 106 in 1991 to 290 as of the end of 1996.
Similarly, foreign listings on Nasdaq increased
from 185 in 1991 to 320 as of the end of 1996.
Conversation with staff of NYSE (Feb. 21, 1997);
Conversation with staff of Corporate
Communications, NASD (Feb. 21, 1997); New York
Stock Exchange, Inc., 1995 Annual Report 3 (1995);
National Association of Securities dealers, Inc.,
1996 Nasdaq Fact Book 37 (1996).
See, e.g., Letter from Catherine McGuire, Chief
Counsel, Division of Market Regulation, SEC, to
(continued...)
======END OF PAGE 18======
dealers have made communications with retail customers more efficient by
offering various services through the Internet.
As technology has broadened the services that can be delivered by both
markets and market intermediaries, market services have become unbundled
from traditional brokerage or exchange services. While some entities that
perform brokerage services have also begun to perform some of the
traditional functions of a stock exchange, other entities (including
information vendors, service bureaus, and routing services) now provide
many of the services historically provided by exchanges and broker-dealers.
One significant example of this has been the development and growing
popularity of alternative trading systems, such as the Real-Time Trading
Service operated by Instinet Corporation ("Instinet"), The Island System
("Island"), Portfolio System for Institutional Trading
(...continued)
Jere W. Glover, Chief Counsel for Advocacy, U.S.
Small Business Administration, and Gregory J.
Dean, Jr., Assistant Chief Counsel for Banking and
Finance, U.S. Small Business Administration (Oct.
26, 1996); Letter from Catherine McGuire, Chief
Counsel, Division of Market Regulation, SEC, to
Bruce D. Stuart, Esq. (Aug. 5, 1996); and Letter
from Catherine McGuire, Chief Counsel, Division of
Market Regulation, SEC, to Barry Reder, Esq. (June
24, 1996).
See Arthur M. Louis, Schwab Plays Catchup: Broker
Faces Tough Internet Competition, S.F. Chron.,
Nov. 26, 1996, at C1. See also Letter from
Richard R. Lindsey, Director, Division of Market
Regulation, SEC, to Scott W. Campbell, Vice
President and Associate General Counsel, Charles
E. Schwab & Co. (Nov. 27, 1996).
Island is operated by Datek Securities Corp., a
registered broker-dealer. Island, Instinet, and
other "matching" systems (such as Tradebook, which
is operated by Bloomberg Tradebook LLC) allow
(continued...)
======END OF PAGE 19======
("POSIT"), and the Arizona Stock Exchange ("AZX"),
which allow institutions and other market participants to electronically
execute trades in a variety of ways. These and other
alternative trading systems have grown to account for a significant
percentage of the trading volume of the U.S. securities markets,
particularly within the last five years. In 1994, the Commission's
Division of Market Regulation reported that alternative trading systems
accounted for 13 percent of the volume in Nasdaq securities and 1.4 percent
(...continued)
participants to display firm, priced orders to
other participants and to execute automatically
against other orders in the system.
POSIT is operated by ITG Inc., a registered
broker-dealer. POSIT and other "crossing" systems
allow participants to enter unpriced orders, which
are then executed with matching interest at a
single price, typically derived from the primary
public market for each crossed security.
AZX and other "single-price auction" systems allow
participants to enter priced orders, which the
system then compares to determine the single price
at which the largest volume of orders can be
executed. All orders are then matched and
executed at that price.
In addition to these systems, more than 140
broker-dealers have notified the Commission that
they operate some type of alternative trading
system, either internally for their own traders or
for their customers and other market participants.
Registered broker-dealers that operate or
otherwise sponsor alternative trading systems are
required to comply with periodic reporting and
recordkeeping requirements pursuant to Rule 17a-23
under the Exchange Act. 17 CFR 240.17a-23. See
generally Division of Market Regulation, Market
2000: An Examination of Current Equity Market
Developments app. IV (1994) (hereinafter Market
2000 Study) (general description of proprietary
trading systems).
======END OF PAGE 20======
of the trading volume in NYSE-listed securities. In
comparison, the Commission estimates that alternative trading systems
currently handle almost 20 percent of the orders in Nasdaq securities and
almost 4 percent of orders in NYSE-listed stocks.
Technology has also significantly altered the operation of exchange
and OTC markets. For example, most exchanges have designed systems that
allow members to route orders electronically to the exchange for
execution. The NYSE has also established after-hours crossing
systems that automate the execution of single stock orders and baskets of
securities, and the Cincinnati Stock Exchange ("CSE") is now a
fully automated exchange where members effect transactions through
See Market 2000 Study, supra note 14, at Study II-
13.
The NYSE's SuperDOT (Designated Order Turnaround)
system enables firms to transmit market and limit
orders in all NYSE-listed securities directly to
the specialist post for execution. Some NYSE
members also allow selected institutional
customers to route their orders through the
members' connection to SuperDOT. Similar systems
are operated by the following exchanges: the
American Stock Exchange ("Amex") (Automated Post
Execution Reporting System, or AutoPERS), the
Boston Stock Exchange ("BSE") (BSE Automated
Communication and Order Routing Network, or
BEACON), the Chicago Board Options Exchange
("CBOE") (the RAES system), the Chicago Stock
Exchange ("CHX") (Midwest Automatic Execution
System, or MAX), the Pacific Exchange ("PCX")
(Pacific Computerized Order Access System, or
P/COAST), and the Philadelphia Stock Exchange
("Phlx") (Phlx Automated Communication and
Execution System, or PACE).
See Securities Exchange Act Release No. 29237 (May
24, 1991), 56 FR 24853 (May 31, 1991); Securities
Exchange Act Release No. 32368 (May 25, 1993), 58
FR 31565 (June 3, 1993).
======END OF PAGE 21======
computers located in their own offices. Dealer markets have
been similarly transformed. Dealer markets traditionally consisted of
loosely organized groups of individual dealers that traded securities OTC,
without formal consolidation of orders or trading. As individual dealers
and associations of dealers have employed technology to make OTC markets
more efficient, however, dealer markets in certain instruments have become
organized to such an extent that they have assumed many of the
characteristics of exchange markets. This is particularly true in markets
that trade instruments that are also listed on registered exchanges. For
example, the Nasdaq market, operated by the National Association of
Securities Dealers, Inc. ("NASD"), consolidates trading interest of
multiple dealers on a computer screen that is displayed in real-time to its
members and provides a mechanism for dealers to update displayed
quotations. Additional services, such as SelectNet, allow
dealers in the Nasdaq market to trade electronically. Through this
technology, the NASD has been able to coordinate the dealer market more
efficiently.
First organized in 1884, the CSE initially
operated with a physical trading floor which it
began phasing out in 1976. SEC, Report on the
Practice of Preferencing Pursuant to Section
510(c) of the National Securities Markets
Improvement Act of 1996, 24 (1997) (hereinafter
Preferencing Report).
Like exchange markets, the NASD imposes
obligations on market makers to provide a
continuous source of liquidity for Nasdaq-traded
securities, establishes minimum qualifications
that issuers must meet in order for their
securities to be quoted on the consolidated
computer screen, and sets enforceable rules that
govern the priorities dealers must give to certain
orders.
======END OF PAGE 22======
Overall, these developments have benefited investors by increasing
efficiency and competition, reducing costs, and spurring further
technological advancement of the entire market. In particular, for those
market participants that have access to alternative trading systems, these
systems have provided opportunities for the direct execution of orders
without the active participation of an intermediary. Alternative markets
are likely to grow as technology continues to drive the evolution of the
equity markets.
B. Market Regulation
Whether trading electronically or through human intervention,
investors are more likely to trade on a market when prices are current and
reflect the value of securities, when they are confident that they will be
able to buy and sell securities easily and inexpensively, and when they
believe that they can trade on a market without being defrauded or without
other investors having an unfair advantage. The competition for global
investment capital among the world's exchanges and the many opportunities
available to U.S. and foreign investors make it more important than ever
for U.S. exchanges to protect these investor interests in order to attract
order flow. Appropriate regulation is often necessary to protect these
interests, by helping to ensure fair and orderly markets, to prevent fraud
and manipulation, and to promote market coordination and competition for
the benefit of all investors.
Experience in both the United States and world
markets has repeatedly shown that commercial
incentives alone are insufficient to protect
investors adequately and ensure fair markets. In
adopting the Exchange Act, Congress noted that,
however zealously exchange authorities may
(continued...)
======END OF PAGE 23======
In the United States, Congress decided that these goals should be
achieved primarily through the regulation of exchanges and through
authority it granted to the Commission in 1975 ("1975
Amendments") to adopt rules that promote (1) economically
efficient execution of securities transactions, (2) fair competition, (3)
transparency, (4) investor access to the best markets, and (5) the
opportunity for investors' orders to be executed without the participation
of a dealer. In promulgating the Exchange Act, Congress gave
the Commission means to achieve these and other goals of
regulation, by requiring every market that meets the definition
(...continued)
supervise the business conduct of their members,
the interests with which they are connected
frequently conflict with the public interest. H.R.
Rep. No. 1383, 73rd Cong., 2d Sess. at 4 (1934);
S. Rep. No. 792, 73rd Cong., 2d Sess. (1934). See
also SEC, Statement of the Securities and Exchange
Commission on the Future Structure of the
Securities Markets (Feb. 2, 1972), 37 FR 5286
(Feb. 4, 1972) (hereinafter Future Structure
Statement). Legislative history to key Exchange
Act amendments adopted in 1975 also points to the
need for regulation. See, e.g., S. Rep. No. 75 and
H.R. Rep. No. 229, infra note 22. See also SEC,
Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the
Nasdaq Market (1996) (hereinafter NASD 21(a)
Report).
Pub. L. No. 29, 89 Stat. 97 (1975).
See S. Rep. No. 75, 94th Cong., 1st Sess. 8
(1975); H.R. Rep. No. 229, 94th Cong., 1st Sess 92
(1975). See also Exchange Act 11A(a)(1), 15
U.S.C. 78k-1(a)(1).
Congress also directed the Commission in the 1975
Amendments to advance the concept of equal
regulation so that persons enjoying similar
privileges, performing similar functions, and
(continued...)
======END OF PAGE 24======
of "exchange" under the Exchange Act to either register as a national
securities exchange or be exempted from registration on the basis of
limited transaction volume. Congress also gave the exchanges
authority to enforce their members' compliance with the goals of the
securities laws and, in 1983, required every broker-dealer to become a
member of an exchange or securities association.
As SROs, every registered exchange and securities association is required
to assist the Commission in assuring fair and honest markets, to have
effective mechanisms for enforcing the goals of regulation, and to submit
(...continued)
having similar potential to affect markets would
be treated equally. The Commission was charged
with ensuring that no member or class of members
had an unfair advantage over other members as a
result of a disparity in regulation not necessary
or appropriate to further the objectives of the
Exchange Act. See H.R. Rep. No. 229, supra note
22.
There are currently eight registered national
securities exchanges and one exempted exchange.
AZX (formerly known as Wunsch Auction Systems) was
exempted from the registration requirements of
Sections 5 and 6 of the Exchange Act, 15 U.S.C.
78e and 78f, based on the exchange's expected
limited volume in trading of securities. See
Securities Exchange Act Release No. 28899 (Feb.
20, 1991), 56 FR 8377 (Feb. 29, 1991) (hereinafter
AZX Exemptive Order). See also Securities
Exchange Act Release No. 37271 (June 3, 1996), 61
FR 29145 (June 7, 1996).
Markets operated by registered securities
associations serve many of the same functions as
exchanges. Registered securities associations are
regulated under Section 15A of the Exchange Act,
15 U.S.C. 78o-1, and are subject to requirements
that are virtually identical to those applicable
to registered exchanges under the Exchange Act.
See Pub. L. No. 38, 97 Stat. 205 (1983).
======END OF PAGE 25======
their rules for Commission review. This statutory structure has given the
Commission ample authority to oversee securities markets and ensure
compliance with the Exchange Act. Although regulation cannot prevent all
manipulation, fraud, or collusion, it has proven effective in ridding
markets of the most egregious of these practices and consequently in
inspiring a high degree of investor confidence.
As a result of the technologically-driven developments discussed
above, however, the distinctions among market service providers have become
blurred, making it more difficult to determine whether any particular
entity operates as an exchange, OTC market, broker, or dealer. For
example, alternative trading systems incorporate features of both
traditional markets and broker-dealers. Like traditional exchanges,
alternative trading systems centralize orders and give participants control
over the interaction of their orders. Like traditional broker-dealers,
alternative trading systems are proprietary and, in some cases, maintain
trading desks that facilitate participant trading. Because the activities
of alternative trading systems include both traditional exchange and
broker-dealer functions, it is often unclear whether such systems should
register as exchanges, broker-dealers, or both. Under the existing
statutory structure enacted by Congress, however, exchanges and broker-
dealers are subject to significantly different obligations and
responsibilities.
To date, the Commission has regulated many alternative markets as
broker-dealers, rather than as exchanges, in order to foster the
development of innovative trading mechanisms within the existing statutory
======END OF PAGE 26======
framework. The determination as to whether any particular
alternative trading system should be regulated as an exchange or broker-
dealer has been decided on a case-by-case basis. This
regulatory approach has had two significant, unintended effects: (1) it
has subjected alternative trading systems to a regulatory scheme that is
not particularly suited to their market activities; and (2) it has impeded
effective integration, surveillance, enforcement, and regulation of the
U.S. markets as a whole.
1. The Current Regulatory Approach Applies Inappropriate
Regulation to Alternative Trading Systems
As broker-dealers, alternative trading systems are subject to
regulation designed primarily to address traditional brokerage activities
rather than market activities. For example, broker-dealers are
See infra notes 120 to 124 and accompanying text.
Since 1991, the Commission staff has given
operators of trading systems assurances that it
would not recommend enforcement action if those
systems operated without registering as exchanges.
As a result, to date, many automated trading
markets have not been required to register as
exchanges and have instead been regulated as
broker-dealers. For a list of no-action letters
issued to system sponsors until the end of 1993
and a short history of the Commission's oversight
of such systems, see Securities Exchange Act
Release No. 33605, 59 FR 8368, 8369-71 (Feb. 18,
1994) ("Rule 17a-23 Proposing Release"). See also
Letters from the Division of Market Regulation to:
Tradebook (Dec. 31, 1996); The Institutional Real
Estate Clearinghouse System (May 28, 1996);
Chicago Board Brokerage, Inc. and Clearing
Corporation for Options and Securities (Dec. 13,
1995).
Broker-dealers have a responsibility under the
Exchange Act for ensuring their own (and their
(continued...)
======END OF PAGE 27======
required to become members of the Securities Investor Protection
Corporation ("SIPC"). While this membership is designed to protect
customer funds and securities held by brokers, few alternative trading
systems hold customer funds or securities. In addition,
broker-dealers are required to be members of an SRO. Thus, alternative
trading systems are subject to oversight by exchanges and the NASD, which
operate their own markets. Because these markets often compete with
alternative trading systems for order flow, there is an inherent conflict
(...continued)
employees') compliance with the federal securities
laws and with the rules of all relevant SROs.
Broker-dealer requirements generally focus on
ensuring adequate employee supervision, financial
responsibility and sufficient capital, and fair
dealing with customers, including protection of
customers' securities and funds, and monitoring
sales practices.
Rather than hold customer funds or securities,
most alternative trading systems require their
customers to arrange for trades executed on the
system to be cleared through another broker-
dealer. See, e.g., Letter from Brandon Becker,
Director, Division of Market Regulation, SEC, to
Lloyd H. Feller, Esq., Morgan, Lewis & Bockius
(Sep. 9, 1993) (Lattice trading system to have
trades cleared and settled by a registered broker-
dealer designated by respective system
participants); Letter from Larry E. Bergmann,
Associate Director, Division of Market Regulation,
SEC, to Larry E. Fondren, Intervest Financial
Services, Inc. (Nov. 24, 1992) (CrossCom Trading
Network to use WFS Clearing Services, Inc.);
Letter from William H. Heyman, Director, Division
of Market Regulation, SEC, to Daniel T. Brooks,
Cadwalader, Wickersham & Taft (Nov. 25, 1991)
(LIMITrader to use Mabon Securities Corp. as its
initial clearing broker); and Letter from William
H. Heyman, (then) Deputy Director, Division of
Market Regulation, SEC, to Richard S. Soroko,
Esq., Lippenberger, Thompson & Welch (May 16,
1991) (Portfolio Trading Services, Inc. to use
Ernst & Company as its clearing broker).
======END OF PAGE 28======
between SROs' competitive concerns as markets and their regulatory
obligations to oversee alternative trading systems.
Regulating alternative trading systems as traditional broker-dealers,
therefore, requires compliance by these systems with obligations that, in
many cases, are not pertinent to their principal activities. As discussed
below, traditional broker-dealer regulation also fails to address concerns
raised by alternative trading systems' market activities.
2. The Current Regulatory Approach Impedes Effective Regulation
The Commission has repeatedly evaluated whether the case-by-case no-
action approach has permitted adequate Commission oversight of secondary
trading markets, particularly in light of the growth and evolving market
significance of such systems. Prior to 1993, the low volume and relatively
small number of alternative trading systems appeared to justify such an
approach. In 1993, for example, in an attempt to evaluate the effects of
regulating alternative trading systems as broker-dealers, the Commission's
Division of Market Regulation conducted a study of the U.S. equity
markets. This study concluded that, at that time, the
Commission did not have sufficient regular information to evaluate the
effects of alternative trading systems on the U.S. securities markets.
Therefore, the Division of Market Regulation recommended that the
Commission closely monitor the impact of the proliferation of such systems.
In response to this recommendation, the Commission adopted a recordkeeping
and reporting rule, Rule 17a-23, specifically for broker-dealers that
See Market 2000 Study, supra note 14.
======END OF PAGE 29======
operate alternative trading systems.
Because traditional broker-dealer regulation is not designed to apply
to markets such as alternative trading systems, gaps have developed in the
structures designed to ensure marketwide fairness, transparency, integrity,
and stability. As discussed in greater detail below, the regulation of the
most significant alternative trading systems under traditional broker-
dealer regulation calls into question the accuracy of public quotation and
trade information, and the fairness of the public secondary
markets. In addition, such regulation may impair the detection
Rule 17a-23 under the Exchange Act generally
requires U.S. broker-dealers that sponsor broker-
dealer trading systems to provide a description of
their systems to the Commission and report
transaction volume and other activity to the
Commission on a quarterly basis. This rule also
requires that such broker-dealers keep records
regarding system activity and to make such records
available to the Commission. 17 CFR 240.17a-23.
See also Securities Exchange Act Release No. 35124
(Dec. 20, 1994), 59 FR 66702 (Dec. 28, 1994).
Commenters have repeatedly suggested that the
regulatory disparity between exchanges and broker-
dealers gives a competitive advantage to
alternative trading systems. Concern about this
regulatory dichotomy has been voiced by many
commenters. Industry and congressional commenters
at various times since 1991 have questioned
whether regulating alternative trading systems
differently from exchanges is advisable. The
NYSE, for example, has stated that:
[R]egulation of participants in our securities
markets should be governed by the principle of
"functional regulation": entities that perform
similar functions should be subject to similar
regulation . . . firms that establish a market
place for providing execution of transactions in
securities pursuant to their own trading rules
should be regulated in a manner similar to
exchanges, regardless of whether they are also
(continued...)
======END OF PAGE 30======
and elimination of fraudulent and manipulative trading, and the mechanisms
to ensure fair and equitable oversight and competition among markets.
a. Market Access and Fairness
While institutional investors are now the dominant players in U.S.
financial markets, the United States still has the highest
percentage of direct individual participation in the stock
markets. Because the needs and interests of small individual
investors, money managers, wealthy speculators, and large pension plans are
not always the same, market regulation is intended to ensure
that these diverse investors are treated fairly and have fair access to
investment opportunities.
(...continued)
brokers and dealers. The name given an entity
should not control the manner in which it is
regulated.
Testimony of Edward A. Kwalwasser, Exec. V.P., NYSE, before
the Telecommunications and Finance Subcommittee, Committee
on Energy and Commerce, U.S. House of Representatives, at 5-
6 (May 26, 1993) (hereinafter Testimony of Edward A.
Kwalwasser).
In 1960, institutions owned only 14.2 percent of
the total $425 billion outstanding U.S. equity
securities. By the end of the third quarter of
1996, the percentage had grown to 52.3% of the
total $9,387 billion of outstanding U.S. equity
securities. Conversation with staff of the
Securities Industry Association (Feb. 21, 1997).
From 1989 to 1995, the percentage of U.S.
households having direct or indirect stock
holdings jumped from 31.7% to over 41%. See
Arthur B. Kennickell and Annika E. Sunden, Family
Finances in the U.S.: Recent Evidence from the
Study of Consumer Finances, Fed. Reserve Bull.,
Jan. 1997, at 1.
Electronic Bulls & Bears, supra note 5, at 29.
======END OF PAGE 31======
Specifically, the Exchange Act requires registered exchanges and
securities associations to consider the public interest in administering
their markets, to allocate reasonable fees equitably, and to
establish rules designed to admit members fairly. While these
provisions are based on the principle that qualified market participants
should have fair access to the nation's securities markets, they are not
intended to limit exchanges from having reasonable standards for
access. Rather, fair access requirements are intended to
prohibit unreasonably discriminatory denials of access. A denial of access
would be reasonable, for example, if it were based on unbiased standards,
such as capital and credit requirements, and if these standards were
applied fairly.
The Exchange Act also requires registered exchanges and securities
associations to establish rules that assure fair representation of members
and investors in selecting directors and administering their
organizations. The purpose of this requirement is to protect
the rights and interests of the diverse members of registered exchanges and
Exchange Act 6(b)(4), 15 U.S.C. 78f(b)(4);
Exchange Act 15A(b)(5), 15 U.S.C. 78o-3(b)(5).
Exchange Act 6(b)(2) and 6(c), 15 U.S.C. 78f(b)(2)
and (c); Exchange Act 15A(b)(8); 15 U.S.C. 78o-
3(b)(8).
"[R]estraints on membership cannot be justified as
achieving a valid regulatory purpose and,
therefore, constitute an unnecessary burden on
competition and an impediment to the development
of a national market system." H.R. Rep. No. 123,
94th Cong., 1st Sess. 53 (1975).
Exchange Act 6(b)(3), 15 U.S.C. 78f(b)(3);
Exchange Act 15A(b)(4), 15 U.S.C. 78o-3(b)(4).
======END OF PAGE 32======
securities associations. In addition, because registered exchanges and
securities associations are also SROs, they exercise governmental powers,
such as the imposition of disciplinary sanctions on their members. Fair
representation on the body responsible for disciplining members is,
therefore, critical to the impartial enforcement of SRO rules.
Market regulation is also designed to remove barriers to fair
competition, by prohibiting the rules of registered exchanges and
securities associations from being anticompetitive, and by
providing for Commission review of the rules of registered exchanges and
securities associations. To further emphasize the goal of
vigorous competition, Congress required the Commission to consider the
competitive effects of exchange rules, as well as the
Commission's own rules.
The Commission's authority to review the actions of registered
exchanges and securities associations has prevented the implementation of
numerous rules that would have been anticompetitive or otherwise
detrimental to the market. For example, in December 1990, the American
Stock Exchange ("Amex") submitted a rule proposal to the Commission that
would have excluded the orders of competing dealers (i.e., regional
Exchange Act 6(b)(8), 15 U.S.C. 78f(b)(8);
Exchange Act 15A(b)(9), 15 U.S.C. 78o-3(b)(9).
Exchange Act 19(b)(1), 15 U.S.C. 78s(b)(1). See
infra notes 188 to 205 and accompanying text
(discussion of obligations of exchanges and
securities associations to file rules and rule
changes with the Commission).
Exchange Act 6(b)(6), 15 U.S.C. 78f(b)(6).
Exchange Act 23(a), 15 U.S.C. 78w(a)(2).
======END OF PAGE 33======
exchange specialists and third market makers) from its order routing system
and would have imposed trading restrictions on competing dealers in Amex
securities. Because the exclusions and restrictions applied only to
competing dealers and not to other off-floor broker-dealers trading for
their own accounts, the proposal raised market access and competitive
concerns. After receiving numerous negative public comments
regarding the Amex's proposal, the Commission staff recommended that the
Amex either amend or withdraw the proposal. Similarly, several
exchanges have proposed prohibiting customer orders from being executed
through the exchanges' automated systems for guaranteed execution of small
customer orders, if those customers used computer and communications
technology to generate and transmit those orders. Such a proposal, if
implemented, would have had the effect of discouraging the use of new,
innovative technology. The tendency to try to discourage innovation in
order to protect existing practices is not new. In 1987, for example, the
Commission set aside the NYSE's denial of the requests of two of its
members for permission to install telephone connections on the floor to
Securities Exchange Act Release No. 28741 (Jan. 3,
1991), 56 FR 1038 (Jan. 10, 1991). The proposal
would have required that orders for the account of
competing dealers: (1) yield priority and parity
to all other off-floor orders; (2) accept parity
with orders for an account of an Amex specialist;
and (3) be excluded from the Amex's order routing
system, the Post Executions Reporting system. The
Amex subsequently amended its proposal.
Securities Exchange Act Release No. 30161 (Jan. 7,
1992), 57 FR 1502 (Jan. 14, 1992).
See Market 2000 Study, supra note 14, at app. III,
at 11. In 1994, the Amex withdrew its proposal.
======END OF PAGE 34======
enable the members to communicate with their customers.
The fair access and treatment requirements in the Exchange Act are
intended to ensure that exchanges and securities associations operating
markets treat investors and their participants fairly. Under the current
regulatory approach, however, there is no regulatory redress for unfair
denials or limitations of access by alternative trading systems, or for
unreasonably discriminatory actions taken against, or retaliatory fees
imposed upon, participants in these systems. The availability of redress
for such discriminatory actions may not be critical when alternative
trading systems disclose any discriminatory practices to their participants
and when market participants are able to substitute the services of one
alternative trading system with those of another. However, when an
alternative trading system has no other serious competitor, such as when it
has a significantly large percentage of the volume of trading,
discriminatory actions may be anticompetitive because market participants
must use such trading system to remain competitive. Similarly, significant
changes in the operations of alternative trading systems are not subject to
either Commission or SRO review -- even those changes that may be
anticompetitive, unfair to a particular group of market participants, or
that have significant effects on the primary public markets.
b. Market Transparency and Coordination
Securities markets have become increasingly interdependent because of
the opportunities technology provides to link products, implement complex
See In the Matter of the Application of William J.
Higgins and Michael D. Robbins, Admin. Proc. No.
3-6609, Securities Exchange Act Release No. 24429
(May 6, 1987).
======END OF PAGE 35======
hedging strategies across markets, and trade on multiple markets
simultaneously. While these opportunities benefit many investors, they can
also create misallocations of capital, widespread inefficiency, and trading
fragmentation if markets do not coordinate. Moreover, a lack of
coordination among markets can increase system-wide risks. Congress
adopted the 1975 Amendments, in part, to address these potential negative
effects of a proliferation of markets. In the 1975 Amendments,
Congress specifically endorsed the development of a national market system,
and sought to clarify and strengthen the Commission's authority to promote
the achievement of such a system. Because of uncertainty as to how
technological and economic changes would affect the securities markets,
Congress explicitly rejected mandating specific components of a national
market system. Instead, Congress granted the Commission
"maximum flexibility in working out the specific details" and "broad
discretionary powers" to implement the development of a national market
system in accordance with the goals of the 1975 Amendments.
See generally S. Rep. No. 75 and H.R. Rep. No.
229, 94th Cong., supra note 22.
S. Rep. No. 75, supra note 22, at 2, 8; H.R. Rep.
No. 229, supra note 22. "[T]he increasing tempo
and magnitude of the changes that are occurring in
our domestic and international economy make it
clear that the securities markets are due to be
tested as never before," and that it was,
therefore, important to assure "that the
securities markets and the regulations of the
securities industry remain strong and capable of
fostering [the] fundamental goals [of the Exchange
Act] under changing economic and technological
conditions." S. Rep. No. 75, supra note 22, at 3.
S. Rep. No. 75 and H.R. Rep. No. 229, supra note
22.
======END OF PAGE 36======
The SROs and the Commission have worked hard to achieve these
goals.
Recent evidence suggests that the failure of the current regulatory
approach to fully coordinate trading on alternative trading systems into
national market systems mechanisms has impaired the quality and pricing
efficiency of secondary equity markets, particularly in light of the
explosive growth in trading volume on such alternative trading systems.
Although these systems are available to some institutions, orders on these
systems frequently are not available to the general investing public. The
ability of market makers and specialists to display different and
potentially superior prices on these alternative trading systems than those
displayed to the general public created, in the past, the potential for a
two-tiered market.
For example, during the Commission's recent investigation of Nasdaq
For example, the Intermarket Communications Group
links the Commission, the Commodity Futures
Trading Commission, and the SROs for the major
securities and futures markets. During periods of
market stress this interagency and intermarket
coordination helps to minimize uncertainty and
improve communication for the benefit of investors
trading in all U.S. markets. In addition, market-
wide trading halts imposed by circuit breaker
procedures limit credit risk by providing a brief
respite amid frenetic trading, which allows market
participants to ensure the solvency of their
counterparties. These planned, coordinated
trading halts also facilitate price discovery by
providing an opportunity to publicize order
imbalances in order to attract value traders, and
cushion the impact of market movements that would
otherwise damage a market's infrastructure.
See Securities Exchange Act Release No. 36310
(Sept. 29, 1995), 60 FR 52792 (Oct. 10, 1995)
(hereinafter Order Handling Rules Proposing
Release).
======END OF PAGE 37======
trading, analyses of trading in the two most significant
trading systems for Nasdaq securities (Instinet and SelectNet) revealed
that the majority of bids and offers displayed by market makers in these
systems were better than those posted publicly on Nasdaq.
Moreover, the Commission found that, because they could trade with other
market professionals through non-public alternative trading systems, market
makers did not have a sufficient economic incentive to adjust their public
quotations to reflect more competitive prices. Ultimately, the
wider spreads quoted publicly by market makers increased the transaction
costs paid by public customers, impaired the ability of some institutional
Following the filing of several class action
lawsuits alleging collusion among Nasdaq market
makers and public allegations that Nasdaq market
makers routinely refused to trade at their
published quotes, intentionally reported
transactions late in order to hide trades from
other market participants, and engaged in other
market practices detrimental to individual
investors, the Commission opened a formal inquiry
to investigate the functioning of the Nasdaq
market and to determine whether the NASD was
complying fully with its obligations as an SRO.
In 1996, as a result of the investigation, the
Commission instituted enforcement proceedings
against the NASD pursuant to Section 19(h) of the
Exchange Act and issued a report under Section
21(a) of the Exchange Act detailing the
Commission's findings. See NASD 21(a) Report,
supra note 20.
These conclusions are based on Instinet and
SelectNet data for the months April through June
1994. See NASD 21(a) Report, supra note 20, at
notes 48 to 52 and accompanying text.
The Commission found that "the ability of market
makers to attract trading interest through
Instinet allowed them to trade without using odd-
eighth quotes and narrowing the Nasdaq spread."
NASD 21(a) Report, supra note 20, at 20.
======END OF PAGE 38======
investors to obtain favorable prices in those securities, and placed
institutions at a potential disadvantage in price negotiations.
In response to these findings, the Commission recently took steps to
bring greater transparency into the trading environment of certain
alternative trading systems. In September 1996, the Commission adopted
rules that require a market maker or specialist to make publicly available
any superior prices that it privately offers through certain types of
alternative trading systems known as electronic communications networks, or
ECNs. The new rules permit an ECN to fulfill these obligations
on behalf of market makers using its system, by submitting its best market
maker bid/ask quotations to an SRO for inclusion into public quotation
displays ("ECN Display Alternative").
These rules, however, were not intended to fully coordinate trading on
alternative trading systems with public market trading. While these rules
will help integrate orders on certain trading systems into the public
quotation system, they only affect trading that is conducted by market
makers and specialists; activity of other participants on alternative
trading systems remains undisclosed to the public market unless the system
NASD 21(a) Report, supra note 20, at 18.
ECNs include any automated trading mechanism that
widely disseminates market maker orders to third
parties and permits such orders to be executed
through the system, other than crossing systems.
See Securities Exchange Act Release No. 37619A
(Sept. 6, 1996), 61 FR 48290 (Sept. 12, 1996)
(hereinafter Order Handling Rules Adopting
Release). Currently, all ECNs are broker-dealer
trading systems, as defined in Exchange Act Rule
17a-23, and are sponsored through registered
broker-dealers.
======END OF PAGE 39======
voluntarily undertakes to disclose all of its best bid/ask
prices. Moreover, whether an ECN reflects the best bid/ask
quotations on behalf of market makers and specialists that participate in
its system is wholly voluntary. Specifically, ECNs are under
no obligation to integrate orders submitted into their systems into the
public quotation system, and the central quotation system is not currently
Because such trading interest remains undisclosed,
within certain alternative trading systems non-
market maker participants are able to display
prices that lock and cross the public quotations.
If the quotes of such participants were also
disclosed to the public, it could result in
improved price opportunities for public investors.
There is already divergence among ECNs in the
extent to which they have chosen to integrate non-
market maker orders into the prices they display
to the public. Of the four ECNs that are
currently linked to Nasdaq, two ECNs display to
the public the best prices of any orders entered
into their systems (including both market makers
and institutions). One ECN displays to the public
the best price of any visible order entered into
its system by market makers or institutions, but
does not display any orders that are designated as
"reserve orders" (which may interact with orders
entered into the ECN's system, but are not
generally displayed to participants in the ECN).
The fourth ECN displays to the public only orders
of market makers and those institutional customers
that affirmatively choose to have their orders so
displayed.
To date, four trading systems have elected to
display quotes under the ECN alternative. See
Letters dated January 17, 1997 from Richard R.
Lindsey, Director, SEC to: Charles R. Hood, Senior
V.P. and General Counsel, Instinet Corporation
(recognizing Instinet as an ECN); Joshua Levine
and Jeffrey Citron, Smith Wall Associates
(recognizing the Island System as an ECN); Gerald
D. Putnam, President, Terra Nova Trading, LLC
(recognizing the TONTO System, now known as
Archipelago, as an ECN); and Roger D. Blanc,
Wilkie Farr & Gallagher (counsel to Bloomberg)
(recognizing Bloomberg Tradebook as an ECN).
======END OF PAGE 40======
required to accept ECNs as participants.
Because a majority of trading interest on alternative trading systems
is not integrated into the national market system, price transparency is
impaired and dissemination of quotation information is incomplete. These
developments are contrary to the goals the Commission enunciated over
twenty years ago when it noted that an essential purpose of a national
market system
is to make information on prices, volume, and quotes for securities in
all markets available to all investors, so that buyers and sellers of
securities, wherever located, can make informed investment decisions
and not pay more than the lowest price at which someone is willing to
sell, and not sell for less than the highest price a buyer is prepared
to offer.
This development also thwarts congressional goals for a national market
system, where the best trading opportunities are to be made accessible to
all customers, not just those customers who, due to their size or
sophistication, may avail themselves of prices in alternative trading
systems not currently available in the public quotation system.
c. Market Surveillance
Market regulation critically enhances the Commission's ability to
surveil market activity as a whole in order to prevent fraud and
manipulation, which can jeopardize market integrity and stability.
Exchanges and securities associations such as the NASD act as SROs and, as
Future Structure Statement, supra note 20, at 9-10
(emphasis added). See also, SEC, Policy Statement
of the Securities and Exchange Commission on the
Structure of a CentralMarket System 25-28 (1973).
======END OF PAGE 41======
such, are responsible not only for complying with the Exchange Act, but
also for carrying out the purposes of the Exchange Act, principally by
enforcing member compliance with the provisions of the Exchange Act and the
rules promulgated thereunder, as well as the exchanges' or associations'
own rules. This requires exchanges and securities associations
to establish rules and procedures to prevent fraud and manipulation and
promote just and equitable principles of trade, typically by establishing
audit trails, surveillance, and disciplinary programs. It also requires
exchanges and securities associations to enforce the antifraud provisions
of the federal securities laws. These requirements are
essential to ensure that SROs implement the goals established by Congress
vigilantly and effectively. In addition, exchanges and securities
associations serve a critical regulatory function by establishing and
enforcing just and equitable principles of trade, and by providing a
mechanism for preventing inappropriate behavior that damages market
integrity, even if such behavior does not rise to the level of fraud under
the Exchange Act. As a result of these requirements, exchanges and
securities associations carry out much of the day-to-day surveillance for,
and initial investigation of, trading improprieties, rule violations, and
fraud.
Although the broker-dealers that operate many of the alternative
trading systems have certain obligations to individual customers, because
these systems are not SROs, they do not have the same market-wide
Exchange Act 6(b)(1), (5), and (6), 15 U.S.C.
78f(b)(1), (5), and (6); Exchange Act 15A(b)(2),
15 U.S.C. 78o-3(b)(2).
Id.
======END OF PAGE 42======
enforcement and surveillance obligations as registered exchanges and the
NASD. Moreover, SROs' current programs to surveil their own markets for
fraud, insider trading, and market manipulation do not extend to observing
quote activity on alternative trading systems. Specifically, although
trades executed through certain alternative trading systems are reported to
the NASD by either broker-dealer participants in such systems or by the
broker-dealer operating the market, the NASD may not receive a
consolidated picture of trading activity on alternative trading systems.
Because activity on alternative trading systems is only reported to an SRO
after a trade has been executed, SROs cannot fully supervise SROs' members'
activities on those systems. In addition, because alternative
trading systems are often reported as the counterparty to all trades
between institutions executed through their systems, SRO surveillance
mechanisms may not be able to identify the true counterparties of those
trades. As a result, fraudulent or manipulative activity that an
institution is carrying on through an alternative trading system may be
masked by the overall activities of the system's other participants, and go
uninvestigated. As more institutions use alternative trading systems to
trade with each other, rather than with intermediaries, this could result
in significant volume that is not integrated into SRO surveillance
Broker-dealers that operate trading systems have
the same reporting obligations as other broker-
dealers. For trades executed on an alternative
trading system, this means that, depending on the
circumstances, market makers and broker-dealers
trading on the system will report their own
trades, and that the broker-dealer sponsor of the
system will undertake to report trades between
non-broker-dealers.
See NASD 21(a) Report, supra note 20.
======END OF PAGE 43======
operations. Finally, alternative trading systems that compete with systems
operated by SROs have repeatedly questioned whether particular SRO actions
were driven by competitive, rather than regulatory motives. Thus, adequate
oversight of alternative trading systems by SROs may be hindered by
competitive concerns.
d. Market Stability and Systemic Risks
SROs have substantial, ongoing commitments to maintain sufficient
system capacity, integrity, and security. The Commission has instituted a
program to monitor capacity planning at SROs, so that it can take
preemptive action if necessary, and meets with the SROs on a regular basis
and reviews various aspects of their computer operations. In contrast, the
Division of Market Regulation's experience in administering the Order
Handling Rules and other broker-dealer rules has revealed that, in many
cases, ECNs and other alternative trading systems may have serious capacity
problems. Even though they have significant trading volume,
under the current regulatory scheme ECNs and other alternative trading
systems are not required to have sufficient computer capacity to meet
ongoing trading demand or to withstand periods of extreme market volatility
or other short-term surges in trading volume. Failure to integrate
alternative trading systems into the Commission's programs to review and
The Commission is aware of several occasions on
which significant alternative trading systems had
to stop disseminating market maker quotations in
order to keep from closing altogether due to
insufficient system capacity. In one recent
occurrence, an interruption in service at an ECN
immediately following a key market announcement
appears to have seriously affected options market
makers' ability to trade the equities underlying
their options.
======END OF PAGE 44======
enhance the capacity of alternative trading systems jeopardizes efforts to
ensure that all trade execution centers will remain operational during
periods of market stress.
C. Conclusion
In sum, the current regulation of alternative trading systems does not
address the market activities performed by such systems. As a result, such
regulation may not have effectively met the congressional goals of
protecting market participants from fraud and manipulation, promoting
market coordination and stability, and ensuring regulatory fairness and
fair competition.
Question 1: The Commission seeks comment on the concerns identified
above and invites commenters to identify other issues raised by the
current approach to regulating alternative trading systems.
Question 2: Are the concerns raised in this release with regard to
the operation of alternative trading systems under the current
regulatory approach unique to such systems? To what extent could
these concerns be raised by broker-dealers that do not operate
alternative trading systems, such as a broker-dealer that matches
customer orders internally and routes them to an exchange for
execution or a broker-dealer that arranges for other broker-
dealers to route their customer orders to it for automated
execution?
III. Approaches to Market Oversight
The Commission recognizes that, in order to promote efficiency,
competition, and capital formation in the securities industry, creation of
new markets or the evolution of existing ones must not be inhibited. At
======END OF PAGE 45======
the same time, the Commission continues to believe that fair and measured
market oversight is valuable to protect investors, ensure the integrity and
fairness of markets, and otherwise promote the goals reflected in the
Exchange Act.
As the problems discussed above illustrate, the current approach for
regulating alternative trading systems may not effectively accomplish these
objectives. New technologies are continually facilitating innovative means
of trading securities, resulting in qualitatively different market
structures. In the next decade, the continued growth of the Internet will
present even more opportunity for change in financial services. This
release solicits comment on whether the current statutory and regulatory
framework is appropriate in light of these myriad developments and new
means of trading securities made possible by emerging technologies. The
release then seeks comment on specific alternatives for addressing these
objectives within the existing securities law framework.
A. Regulatory Structure
As technology continues to drive the evolution of markets, the variety
and combinations of services offered by markets and intermediaries will
continue to blur the distinctions among these entities. Under the Exchange
Act, such distinctions determine the obligations and responsibilities of
each entity towards customers and the market as a whole. In particular,
the Exchange Act categorizes market participants based on their primary
activities, such as an "exchange" function or a "broker-dealer" function.
Although Congress defined the terms "exchange," "broker," and "dealer"
broadly enough to accommodate changes in how these entities carry out their
business, they could not anticipate the variety of entities that would
======END OF PAGE 46======
develop. The Commission invites commenters to analyze whether, in light of
technological advances, market participants might be appropriately
regulated without reference to distinctions between markets and
intermediaries. In the alternative, the Commission solicits comment on
whether new regulatory categories are needed for entities that combine both
market and intermediary functions. The Commission also solicits comment on
what oversight should apply to these categories.
In addition, as explained above, exchanges and broker-dealer
intermediaries each play critical roles in supervising securities
activities. The Commission solicits comment on how any changes to the
regulatory approach would affect these roles.
Finally, the Commission solicits comment on how any changes to the
current statutory and regulatory structure made to accommodate market
innovations could be accomplished without undue cost to existing market
participants, which have invested significantly to comply with the existing
structure.
Question 3: What regulatory approaches would best address the
concerns raised by the growth of alternative trading systems and the
needs of the market? Is the current approach the most appropriate
one?
Question 4: What should be the objectives of market regulation? Are
the goals and regulatory structure incorporated by Congress in the
Exchange Act appropriate in light of technological changes? Are
business incentives adequate to accomplish these goals?
Question 5: Are the regulatory categories defined in the Exchange Act
sufficiently flexible to accommodate changes in market structure? If
======END OF PAGE 47======
not, what other categories would be appropriate? How should such
categories be defined?
B. Regulatory Tools
Technological changes also have significant implications for the tools
the Commission relies on to achieve the goals incorporated by Congress into
the Exchange Act. As discussed in greater detail in Sections IV and V
below, the Commission currently regulates markets largely through its
registration, rule filing, examination, and enforcement programs. In light
of the changes discussed above, the Commission solicits comment on whether
these are effective means of accomplishing congressional goals, and, if
not, what other means might be more appropriate.
For example, many Commission regulations require market participants
to deliver written documents. In order to give broker-dealers and
investment advisers the flexibility to comply with these requirements in
the most cost-effective and efficient manner, the Commission has issued
interpretative guidance regarding the use of electronic communications to
fulfill the delivery requirements of the federal securities
laws. Rather than specifying acceptable types of electronic
delivery, the Commission specified the standards that entities had to
achieve in meeting their delivery requirements electronically, leaving it
to each entity to determine the best way to meet each standard. This
approach allows broker-dealers and investment advisers to avail themselves
of technological innovations without first obtaining regulatory approval.
See Securities Exchange Act Release No. 36345, 60
FR 53458 (Oct. 6, 1995); Securities Exchange Act
Release No. 36346, 60 FR 53468 (Oct. 6, 1995);
Securities Exchange Act Release No. 37183 (May 9,
1996), 61 FR 24652 (May 15, 1996).
======END OF PAGE 48======
The Commission solicits comment on whether such a standard-oriented
approach would be appropriate for the regulation of markets, and, if so,
what these standards should be.
Question 6: Can the Commission regulate markets effectively through
standard-oriented regulation of the type described above?
Question 7: How could the Commission enforce compliance with the
Exchange Act under such a standard-oriented approach?
Question 8: Is the current regulatory framework an effective form of
oversight, in light of technological changes? Are there other
regulatory techniques that would be comparably effective? If so,
would the implementation of such techniques be consistent with
congressional goals reflected in the Exchange Act?
IV. Proposals Under Consideration to Integrate Alternative Trading Systems
into the Existing Regulatory Structure for Market Oversight
Within the existing regulatory framework, the issues currently
associated with alternative trading systems could be addressed in large
part by integrating alternative trading systems more effectively into
national market system mechanisms. Discussed below are two alternative
means of effecting such integration. First, the Commission could continue
to regulate alternative trading systems as broker-dealers and attempt to
integrate these systems more effectively into market regulation mechanisms
through a series of rules applicable to broker-dealers operating such
systems and to SROs overseeing such systems. Second, the Commission could
regulate alternative trading systems as exchanges by expanding the
interpretation of the term "exchange" to cover those alternative trading
systems that engage in many of the same activities as currently registered
======END OF PAGE 49======
exchanges, such as operating an electronic limit order book, or matching or
crossing participant orders. The Commission could then follow a tiered
approach to regulating those alternative trading systems classified as
exchanges. The first tier under this approach would consist of those
alternative trading systems that have low volume or a passive pricing
structure. These trading systems would not be required to register as
national securities exchanges (or as broker-dealers, to the extent that
such trading systems do not also perform customary brokerage
functions), but would be subject to limited requirements. The
second tier under this approach would consist of those alternative trading
systems with a large volume of trading and active price discovery, but that
do not have membership structures. The Commission could require these
trading systems to register as exchanges, but would use its new exemptive
authority to eliminate unnecessary or inappropriate
requirements. Finally, the third tier under this approach
See infra notes 183 to 184 and accompanying text.
The National Securities Markets Improvement Act of
1996 (hereinafter 1996 Amendments), Pub. L. 104-
290, added Section 36 to the Exchange Act, 15
U.S.C. 78mm, which authorizes the Commission to
conditionally or unconditionally exempt any
person, security, or transaction, or any class
thereof, from any provision of the Exchange Act or
rule thereunder, so long as the exemption is
necessary or appropriate in the public interest
and is consistent with the protection of
investors. Section 36 of the Exchange Act does
not authorize the Commission to exempt persons,
securities, transactions, or classes thereof from
Section 15C of the Exchange Act or rules and
regulations issued under that section. Section
15C establishes registration requirements for
government securities brokers and government
securities dealers and gives the U.S. Department
(continued...)
======END OF PAGE 50======
would consist of those traditional exchanges that have membership
governance structures.
Any new regulatory approach to oversight of alternative trading
systems should promote efficiency, competition, and capital formation in
the securities industry, without inhibiting the development of new markets.
At the same time, it is critical to address the problems discussed above.
The Commission solicits comment on the two alternatives for addressing
these issues discussed below, and on whether there are other alternatives
that may address the Commission's concerns.
Question 9: Are there viable alternatives within the existing
Exchange Act structure, other than those discussed below, that would
address the concerns raised by the growth of alternative trading
systems and congressional goals in adopting the Exchange Act?
A. Integrating Alternative Trading Systems into the National Market
System Through Broker-Dealer Regulation
In order to rectify the shortcomings discussed in Section II of this
release, the Commission could build upon its current regulation of
alternative trading systems as broker-dealers. In particular, alternative
trading systems could be overseen and integrated into the NMS through a
combination of broker-dealer regulation and regulation of the SROs that
(...continued)
of the Treasury authority to promulgate rules
governing the activities of these entities. All
of the exemptions pursuant to Section 36 of the
Exchange Act that the Commission is considering in
this concept release could be granted by rule or
regulation. If the Commission determined instead
to issue orders granting exemptive applications,
it would need to adopt procedures for doing so
pursuant to Section 36.
======END OF PAGE 51======
supervise these systems. The Commission took a similar approach in its
recent adoption of the Order Handling Rules (which are designed to
integrate a portion of the trading on ECNs into market transparency
mechanisms) and in its adoption of Rule 17a-23 (which established
recordkeeping and reporting requirements specifically tailored to broker-
dealers operating trading systems).
As discussed below, these broker-dealer regulations could include
requiring those broker-dealers that operate alternative trading systems to
make all orders of participants in those systems available to the public
quotation system. The Commission could also require alternative trading
systems to provide the public with access to such systems in order to
interact with the orders posted by participants of such systems. In
addition, the Commission could impose additional requirements on both the
broker-dealers that operate alternative trading systems and their SROs in
order to more effectively integrate these systems into SRO surveillance
mechanisms. For example, the Commission could require broker-dealers that
operate alternative trading systems to provide more audit trail information
to their SROs, which would help SROs execute their oversight functions, and
could require SROs to use this additional information to integrate these
systems into their surveillance programs. Finally, the Commission could
adopt measures that would help to ensure that alternative trading systems
have adequate systems capacity.
Question 10: What types of alternative trading systems would it be
appropriate to regulate in this manner?
1. Fully Integrating the Orders of All Market Participants into
the Public Quotation System and Facilitating Public Access
======END OF PAGE 52======
to Such Orders
In its efforts to increase competition and transparency in the market,
the Commission has encouraged the development of NMS mechanisms, such as
the Consolidated Tape Association ("CTA"), the Consolidated Quotation
System ("CQS") and the Intermarket Trading System ("ITS"). These
mechanisms make information about trading interest, prices, and volume
widely available to market participants. The Commission has worked to
continuously update and improve the NMS to reflect technological advances.
For example, the new Order Handling Rules require market makers and
specialists to make available publicly any superior prices they privately
offer through ECNs. As an alternative, the new rules permit, but do not
require, an ECN to fulfill these obligations on behalf of the market maker
or specialist by submitting the ECN's best bid and offer to an SRO for
inclusion into the public quotation system.
As discussed above, however, these rules were not intended
to integrate all trading on alternative trading systems into the NMS.
These rules focus only on ensuring that market maker and specialist
activity on alternative trading systems is reflected in their public
quotations. As a result, institutional orders on ECNs remain largely
undisclosed to the public, thus hiding the aggregate trading interest on
alternative trading systems from public view. Therefore, it might be
appropriate to require broker-dealers that operate alternative trading
systems to report all orders submitted by participants,
See supra notes 57 to 60 and accompanying text.
Firm prices for securities, whether such firm
prices are labeled as "orders," "quotes," or
(continued...)
======END OF PAGE 53======
including those of non-broker-dealer participants, for integration into the
public quotation system.
If alternative trading systems are required in some manner to publicly
display the orders of all participants, they could also be required to
provide the public with the ability to execute against those orders. Under
the Order Handling Rules, an ECN that voluntarily displays market makers'
and specialists' quotations to the public must also provide an equal
opportunity for participants and non-participants to execute their orders
against such quotations. Non-participants, however, may only access market
maker and specialist quotations on those ECNs. Alternative trading systems
could be required to provide non-participants with the ability to execute
against all orders in their system, including those of institutions, in a
manner equivalent to that offered participants of the systems. Non-
participants would be granted access on a real-time basis under this
approach and could be charged reasonable fees for such access.
Question 11: If the Commission decided to further integrate
alternative trading systems into the NMS through broker-dealer
regulation, should it require alternative trading systems to submit
all orders displayed in their systems into the public quotation
system? If not, how should the Commission ensure adequate
transparency?
(...continued)
otherwise, could be included in the public
quotation system. Priced orders entered into
alternative trading systems where the orders are
widely disseminated and executable could be viewed
as the functional equivalent of quotations, and
like quotations, would play a key role in the
price discovery process. See also Order Handling
Rules Adopting Release, supra note 57, at 116.
======END OF PAGE 54======
Question 12: If the Commission requires alternative trading systems
to submit all orders displayed in their systems into the public
quotation system, how can duplicate reporting by alternative trading
systems and their participant broker-dealers be prevented?
Question 13: Are there other methods for integrating all orders
submitted into alternative trading systems into the public quotation
system?
Question 14: Are there any reasons that orders available in
alternative trading systems should not be available to the public?
Question 15: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it ensure that non-participants are granted
equivalent access?
Question 16: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it determine whether the fees charged to non-
participants by such systems are reasonable and do not have the effect
of denying access to orders?
Question 17: Are there any reasons that non-participants should not
be able to execute against orders of participants in alternative
trading systems?
2. Improving the Surveillance of Trading Conducted on
Alternative Trading Systems
As discussed below, alternative trading systems may not be subject to
real-time surveillance for market manipulation and fraud. Broker-dealers
that operate these systems are not required to actively surveil the conduct
======END OF PAGE 55======
of system participants to ensure against fraud and manipulation. Instead,
as discussed above, these surveillance responsibilities lie with the SROs.
SROs, however, do not actively incorporate alternative trading systems into
their real-time surveillance programs, and broker-dealer trade reporting
conventions restrict SRO surveillance capabilities.
Trading by institutions on alternative trading systems is effectively
hidden from SRO programs designed to detect fraud and manipulation. SRO
surveillance systems generate "alerts" that, in their most basic form,
indicate when trading in a particular security is outside of normal trading
patterns, such as when a previously inactive entity suddenly begins
actively trading. Broker-dealers operating alternative trading systems,
however, are not required to report the identities of the counterparties to
a trade to their supervising SRO. Instead, the broker-dealer may report
the trade to the SRO as its own trade. Therefore, SRO surveillance
programs do not "look through" the alternative trading system to the actual
counterparties conducting the trading on such systems. Because the SRO
system views the broker-dealer operating the system as the counterparty to
trades, unusual trading activity of a participant in an alternative trading
system may not trigger an alert. While the anonymity provided by the
broker-dealer trading system reporting the trade may be desirable to some
because it allows traders to hide their trading strategies from other
market participants, it also represents an opportunity for market
manipulation that is increasingly difficult for SROs to detect.
In addition, SRO surveillance programs typically are constructed
around activity in particular securities. Several alternative trading
systems are designed to provide a liquid market in securities that are not
======END OF PAGE 56======
traded on exchanges or Nasdaq, such as limited partnerships and certain
derivatives. Because SRO surveillance currently focuses primarily on
trading in securities listed or approved for trading on the market operated
by that SRO, activity on systems trading other securities (particularly
non-equity securities) may not receive adequate surveillance for fraud and
market manipulation.
Finally, although a broker-dealer is generally obligated to report a
trade executed on an alternative trading system to its SRO, the
SRO does not receive a composite picture of orders available on that
alternative trading system on a real-time basis. Consequently, the SRO is
not able to integrate the activity on an alternative trading system into
its information about activity in that security on its own market.
For these reasons, if alternative trading systems continue to be
regulated as broker-dealers, it may be appropriate to require such systems
to provide their SRO, on an automated basis, with real-time information
about trading on the systems (including, where appropriate, parties to a
trade), in order to enable the SRO to improve its surveillance of such
trading. The Commission notes that the identities of the counterparties to
a trade would not be made publicly available, but would be provided solely
to the market surveillance department of an SRO. In addition, in order for
SROs to incorporate the trading on alternative trading systems into their
real-time surveillance programs, SROs would have to understand in much
greater detail than they do today the manner in which prices are
established on alternative trading systems. This would probably require
SROs, for example, to examine the trading algorithms, including the
See, e.g., NASD Manual Rules 4630-32.
======END OF PAGE 57======
programming code, of alternative trading systems. Alternative trading
systems would also have to notify SROs of changes to their system.
Further, because alternative trading systems that trade non-NMS securities
are not currently included within SROs' primary surveillance programs, SROs
may have to broaden the scope of their surveillance activities to include
more active surveillance of trading in securities not listed or quoted on
the market operated by the SRO.
Under this approach, the surveilling SRO would integrate the
additional data provided by the alternative trading systems into the SRO's
audit trail and real-time surveillance function. The SROs could use this
data to enhance their ongoing, real-time surveillance of these alternative
systems by developing specifically tailored surveillance and examination
procedures to detect fraud and manipulation on particular systems and among
systems.
Question 18: Should the Commission require alternative trading
systems to provide additional information (such as identifying
counterparties) to their SRO in order to enhance the SRO's audit trail
and surveillance capabilities?
Question 19: What other methods could the Commission use to enhance
market surveillance of activities on alternative trading systems?
Question 20: Should SROs be required to surveil trading by their
members in securities that are not listed or quoted on the market
operated by that SRO?
3. Ensuring Adequate Capacity of Alternative Trading Systems
As alternative trading systems play an increasingly important role in
the securities markets, their ability to continue to operate during periods
======END OF PAGE 58======
of high volume or volatility becomes critical. Existing standards
regarding the review of the capacities and other operational requirements
of markets could apply to alternative trading systems if they continue to
be regulated as broker-dealers.
The Commission currently receives limited information regarding the
operational procedures of alternative trading systems under Rule 17a-
23. Although that Rule requires system operators to provide
the Commission with a brief description of their trading systems, including
significant systems changes and procedures for reviewing systems capacity,
security, and contingency planning, it does not require alternative trading
systems to adopt such procedures. The Commission in the past has issued
guidance to SROs on developing and implementing policies for assessing the
capacity, security, and contingency planning of their systems.
In particular, the Commission is considering
adopting certain additional procedures, pursuant
to Section 15(b)(7) of the Act, 15 U.S.C.
78o(b)(7), to ensure that alternative trading
systems have adequate facilities and operational
capabilities for the services they provide.
See Item 5, Part I of Form 17A-23, 17 CFR 249.636.
See Securities Exchange Act Release No. 29185 (May
9, 1991), 56 FR 22490 (May 15, 1991); Securities
Exchange Act Release No. 27445 (Nov. 16, 1989), 54
FR 48703 (Nov. 24, 1989). These releases
encourage SROs to establish comprehensive planning
and assessment programs that accomplish three
objectives: (1) each SRO should establish current
and future capacity estimates; (2) each SRO should
conduct capacity stress tests periodically; and
(3) each SRO should obtain an annual independent
assessment of whether the affected systems can
perform adequately in light of estimated capacity
levels and possible threats to the systems. An
"independent review" might be performed by any
qualified party that has the organizational status
(continued...)
======END OF PAGE 59======
To ensure that alternative trading systems have adequate capacity for order
execution and other services they provide, the Commission could consider
whether broker-dealers that operate such systems should be required to
follow similar guidelines. For example, alternative trading systems could
be required to arrange for independent systems reviews, including an
assessment of anticipated capacity requirements, contingency protocols, and
processes for preventing, detecting, and controlling threats to their
systems. In addition, alternative trading systems could be required to
report significant systems outages to the Commission and their SRO on a
real-time basis.
Question 21: Should alternative trading systems be required to follow
guidelines regarding the capacity and integrity of their systems? If
not, how should the Commission address systemic risk concerns
associated with potentially inadequate capacity of alternative trading
systems, particularly those systems with significant volume?
(...continued)
and objectivity such that it operates separately
from and is not controlled by the SRO's technology
staff. The Commission recommended that these
independent reviews evaluate the following areas:
computer operations; telecommunications; systems
development methodology; capacity planning and
testing; and contingency planning. The Commission
also presented the SROs with guidelines for
additional means for providing the Commission with
information regarding automation developments or
enhancements and system outages, specifically: (1)
annual reports through which SRO technical staff
would describe for Division staff the current
automated system operations and planned changes;
(2) SRO notification of the Division of
significant changes to automated systems; and (3)
real-time notification of significant
interruptions of service in SRO automated trading
systems.
======END OF PAGE 60======
Question 22: With what types of standards regarding computer
security, capacity, and auditing of systems, should alternative
trading systems be required to comply?
Question 23: To what extent would complying with systems guidelines
similar to those implemented by exchanges and other SROs require
modification to the current procedures of alternative trading systems?
What costs would be associated with such modifications? How much time
would be required to implement the necessary modifications and systems
enhancements? Please provide a basis for these estimates.
4. Potential Problems with Regulating Alternative Trading
Systems Under the Broker-Dealer Regulatory Scheme
Although broker-dealer regulation provides a framework for integrating
alternative trading systems into the most significant aspects of the NMS,
such an approach may not address certain of the regulatory gaps discussed
above in Section II. First, the broker-dealer approach may not ensure the
fair treatment of investors by alternative trading systems. Second, as
broker-dealers, these systems would continue to be required to comply with
regulations designed for more traditional brokerage activities. For
example, the operators of alternative trading systems would be subject to
oversight and heightened surveillance by SROs, which may operate competing
trading systems. Third, alternative trading systems, even those with a
significant share of trading volume, would not be subject to provisions
designed to address anticompetitive activities.
a. Alternative Trading Systems Would Not Be Subject to
Requirements Designed to Assure Fair Treatment of
Investors
======END OF PAGE 61======
In contrast to national securities exchanges, no regulatory redress
exists for unreasonably discriminatory action taken by a broker-dealer
operating an alternative trading system against a system participant or an
applicant. As discussed above, the ability of
these systems to unreasonably discriminate can have adverse ramifications
for market participants. For example, if a significant percentage of
institutional orders are entered into an alternative trading system,
broker-dealers denied access to that system would lose the opportunity to
interact with that institutional trading interest. They may also be denied
the opportunity to display customer limit orders in a forum where they are
most likely to be executed. Similarly, an alternative trading system that
trades illiquid securities, such as limited partnerships or real estate
derivatives, may provide the only efficient means of locating
counterparties with which to trade in those securities. Investors denied
access to such a system may have limited opportunity to trade those
securities, particularly if other participants in the market primarily
trade those securities through the alternative trading system.
Fair treatment of potential and actual participants becomes more
important as alternative trading systems capture a larger percentage of
overall trading volume and display consistently superior prices,
particularly if there are no viable alternatives to trading on such
Rule 17a-23 requires a sponsor of a broker-dealer
trading system to provide the Commission with a
description of the sponsor's criteria for granting
access to the system. The Rule does not directly
require meaningful disclosure of the underlying
reasons for particular denials of access.
See supra Section II.B.2.a.
======END OF PAGE 62======
systems. The importance of fair treatment by such systems is heightened
during periods of significant market activity. Broker-dealer regulation
may not provide meaningful redress for unfairly discriminatory acts taken
by the operators of these systems. Even if the Commission were to require
reporting of denials of access to a system or its services, investors might
continue to be without regulatory redress for discriminatory actions.
Question 24: Is access to alternative trading systems an important
goal that the Commission should consider in regulating such systems?
If so, are there circumstances in which alternative trading systems
should be able to limit access to their systems (for example, should
the Commission be concerned about access to an alternative trading
system that has arranged for its quotes to be displayed as part of the
public quotation system)?
Question 25: If alternative trading systems were to continue to be
regulated as broker-dealers and were subject to a fair access
requirement, should the Commission consider denial of access claims
brought by participants and non-participants in alternative trading
systems? If not, are there other methods that could adequately
address such claims?
Question 26: Are commenters aware of any unfair denials of access by
broker-dealers operating alternative trading systems, where there were
no alternative trading venues available to the entities denied access?
b. Broker-Dealers that Operate Alternative Trading Systems
Will Still Be Required to Comply with Potentially
Inapplicable Regulation and Be Subject to Oversight by
SROs
======END OF PAGE 63======
Alternative trading systems are currently required to comply with
regulation intended for traditional broker-dealer activities (e.g.,
recommending investment strategies and holding customer funds and
securities). Moreover, they are subject to surveillance by
SROs that operate their own trading systems that may compete with
alternative trading systems. In the past, broker-dealers that operated
alternative trading systems have been reluctant to comply with SRO requests
for compliance data because of their concern that the SRO will use this
confidential business data for purposes unrelated to regulatory oversight.
The broker-dealer approach described above contemplates enhancement of
SRO oversight to integrate these systems into the mechanisms of the NMS,
provide for adequate market surveillance of trading activity on these
systems, and prevent fraud and manipulation. SROs may have concerns about
the resources that would have to be dedicated to enhance surveillance of
alternative trading systems. In addition, alternative trading systems may
object to surveillance by the regulatory arm of those entities with which
they compete for order flow. For example, alternative trading systems may
be reluctant to fully disclose information about the operation of their
trading systems to SROs that operate competing markets. Strict separation
of market and regulatory functions within an SRO (which some SROs have
already undertaken) may help alleviate concerns over whether information
provided to the regulatory arm of an SRO could be used for competitive
purposes.
It may be more desirable for alternative trading systems to be
See supra Section II.B.1.
======END OF PAGE 64======
surveilled by an SRO not under the control of an entity that also operates
a competing market. For example, under Section 15A of the Exchange Act, an
association of brokers and dealers could establish an SRO that does not
operate a market. Such an SRO could be established solely for purposes of
overseeing the activities of unaffiliated markets. The Commission seeks
comment on the advisability and feasibility of such an approach.
Question 27: Would enhanced surveillance of alternative trading
systems by their SROs raise competitive concerns that could not be
addressed through separation of the market and regulatory functions of
the SROs?
Question 28: If alternative trading systems continue to be regulated
as broker-dealers, are there other ways to integrate the surveillance
of trading on alternative trading systems?
Question 29: What is the feasibility of establishing an SRO solely
for the purpose of surveilling the trading activities of broker-dealer
operated alternative trading systems, that does not also operate a
competing market?
c. Alternative Trading Systems Will Be Free to Engage in
Anticompetitive Activities
Broker-dealer regulation is not designed to address anticompetitive
activities. If a traditional broker-dealer acts in an anticompetitive
manner, investors and other market participants always have the option of
dealing with another broker-dealer. If an alternative trading system
operated by a broker-dealer captures a large market share and is a major
forum for price discovery in a particular security, however, other trading
venues may not be comparable. As a result, anticompetitive activities by
======END OF PAGE 65======
that system may have significant effects on investors and other
markets.
Because broker-dealers, unlike SROs, are not subject to non-
discriminatory standards for access or fees, or prevented under the
Exchange Act from using their market position to impose anticompetitive
conditions, alternative trading systems that are regulated as broker-
dealers would not be restricted from engaging in anticompetitive activities
that have a negative impact on investors and other markets.
Question 30: If alternative trading systems continue to be regulated
as broker-dealers, how can the Commission address anticompetitive
practices by such systems?
5. Conclusion
For example, following adoption of the 1975
Amendments, the Commission reviewed SRO rules to
confirm that they were in compliance with the
Exchange Act as amended. Among other things, the
Commission identified several rules that it
considered to be anticompetitive in violation of
the Exchange Act, such as rules that restricted
the types of entities with which their members
could trade. See Securities Exchange Act Release
No. 13027 (Dec. 1, 1976), 41 FR 53557 (Dec. 7,
1976).
Exchange regulation addresses potentially
anticompetitive activities through the
Commission's oversight of SROs and through the
rule filing process. For example, a primary
registered market could institute an after-hours
trading halt for purposes of news dissemination,
but fail to remove that halt until the re-opening
of its own facilities the following trading day,
even if sufficient time has passed to permit the
dissemination of the news. In that situation, the
Commission could act to ensure that the registered
market was not instituting a trading halt to
prevent competitors from engaging in after-hours
trading in its securities.
======END OF PAGE 66======
The approach to regulating alternative trading systems discussed
above, which would continue to regulate alternative trading systems as
broker-dealers, appears to address some of the Commission's concerns
regarding transparency, surveillance, and capacity of alternative trading
systems, while balancing business needs of the alternative trading systems.
In addition, regulation of the operators of alternative trading systems as
broker-dealers has in the past been supported by sponsors of such systems
as an appropriate way to regulate, and as a means of fostering the
development of, these systems. Similarly, some SROs have
expressed their support for basing the regulation of alternative trading
systems on the regulation of their sponsors as broker-dealers.
Question 31: Would this approach be an effective means of addressing
the issues raised by the growth of alternative trading systems? What
would be the benefits of such an approach? What would be the
drawbacks of such an approach?
B. Integrating Alternative Trading Systems into Market Regulation
Through Exchange Regulation
See, e.g., Letter from Daniel T. Brooks,
Cadwalader, Wickersham & Taft (counsel to
Instinet), to Jonathan G. Katz, SEC (Aug. 2, 1989)
at 29 ("When properly analyzed . . . market
structure concerns dictate that Instinet be
regulated as a broker.")
See, e.g., Memorandum accompanying Letter from
James E. Buck, Senior V.P., NYSE, to Jonathan
Katz, SEC (Aug. 2, 1989) at 2 (stating that a rule
based approach to regulating alternative trading
systems "strikes a near optimal balance. It
represents a significant improvement over the 'no-
action' approach, and is significantly superior to
the 'no-filing' approach, in retaining minimal
regulatory 'costs' and yet maximizing the benefit
to the markets.").
======END OF PAGE 67======
As discussed above, regulation of alternative trading systems as
broker-dealers may not address all of the issues raised by the activities
of such systems. A second approach might integrate such systems more fully
into market regulation: rather than continuing to regulate alternative
trading systems as broker-dealers, the Commission could use the exemptive
authority granted under the 1996 Amendments to explore new
approaches to the regulation of exchanges. In particular,
under this approach, the interpretation of the term "exchange" could be
broadened to include any organization that both: (1) consolidates orders of
multiple parties; and (2) provides a facility through which, or sets
material conditions under which, participants entering such orders may
agree to the terms of a trade. This expanded interpretation would
significantly broaden the entities that are considered to be exchanges to
See supra note 68.
In adopting the general exemptive authority
included in the 1996 Amendments, the Report of the
Senate Committee on Banking, Housing and Urban
Affairs made specific reference to alternative
trading systems:
The Committee recognizes that the rapidly changing
marketplace dictates that effective regulation
requires a certain amount of flexibility.
Accordingly, the bill grants the SEC general
exemptive authority under both the Securities Act
and the Securities Exchange Act. This exemptive
authority will allow the Commission the
flexibility to explore and adopt new approaches to
registration and disclosure. It will also enable
the Commission to address issues related to the
securities market more generally. For example,
the SEC could deal with the regulatory concerns
raised by the recent proliferation of electronic
trading systems, which do not fit neatly into the
existing regulatory framework.
S. Rep. No. 293, 104th Cong., 2d Sess. 15 (1996).
======END OF PAGE 68======
include currently registered exchanges, certain broker-dealer trading
systems (including matching and crossing systems), currently exempted
exchanges, certain dealer markets, and other alternative trading systems.
For example, this interpretation would capture systems such as Instinet,
Tradebook, Island, and Terra Nova's Archipelago system, that operate as
electronic limit order books, allowing participants to display buy and sell
offers in particular securities and to obtain execution against matching
offers contemporaneously entered or stored in the system. In addition,
systems that consolidate orders internally for crossing or matching with
display to participants such as POSIT, and organized dealer markets (unless
operated by a registered securities association) that consolidate orders
and set material conditions under which orders can be executed, would also
be encompassed by such an interpretation. While interdealer brokers in
municipal and government securities could be exempted from any revised
interpretation of "exchange," fully automated interdealer brokers would be
covered by this interpretation. Any such reinterpretation of
"exchange" presumably would not be intended to include customary brokerage
activities or the activities of information vendors.
The Commission could then use its exemptive authority under Section 36
of the Exchange Act, as described below, to create a new
category of exchanges that are exempt from most statutory exchange
registration requirements and are subject only to limited obligations
A more detailed discussion of the effects of a
revised interpretation of "exchange" is provided
in Section IV.B.3 infra.
See supra note 68 for a discussion of the
Commission's exemptive authority under Section 36
of the Exchange Act.
======END OF PAGE 69======
designed to address specific concerns related to their market activities.
More significant alternative trading systems could be integrated into the
exchange regulatory scheme, with exemptions for such systems from those
exchange requirements that are unnecessary or inappropriate for
proprietary, automated systems.
At the same time, this type of an approach could potentially open the
door for competing exchanges to use national market systems as a vehicle to
inhibit innovation by alternative trading systems. For example, it is
possible that existing exchanges could try to use participation in joint
national market system mechanisms to set marketwide operational standards
(as conditions of participation in the national market system plans) that
have the effect of inhibiting innovation by alternative trading
systems. As discussed below, the Commission would
anticipate working with existing exchanges and Nasdaq to integrate
alternative trading systems into the national market system without
stifling their innovation.
Question 32: If the Commission reinterpreted the term "exchange," are
For example, as discussed below, national
securities exchanges participate in national
market systems plans, which are jointly drafted
and operated, and the terms of these plans must be
approved by all of the markets that are plan
participants. See infra Section IV.B.4. By
specifying operational requirements that each
exchange must meet in order to participate in the
national market system mechanisms, these plans can
have the effect of setting marketwide standards.
As a result, these plans could be used to require
newly registered exchanges to comply with
particular trading increments, reporting methods,
and fee arrangements, for example.
See infra notes 163 to 169 and accompanying text.
======END OF PAGE 70======
the factors described above (i.e., (1) consolidating orders of
multiple parties and (2) providing a facility through which, or
setting conditions under which, participants entering such orders may
agree to the terms of a trade) sufficient to include the alternative
trading systems described above?
Question 33: Is broadening the Commission's interpretation of
"exchange" to cover diverse markets, and then exempting all but the
most significant of these new exchanges from registration, the most
appropriate way to address the regulatory gaps discussed above and
provide the Commission with sufficient flexibility to oversee changing
market structures?
1. Creating a New Category Called "Exempted Exchanges" for
Smaller and Passive Alternative Trading Systems
The Commission could create a new tier of exchange regulation for most
alternative trading systems by expanding its interpretation of the term
"exchange," as discussed in greater detail in Section IV.B.3. below, and by
exempting from registration alternative trading systems that, although
captured within a broader interpretation of "exchange," do not need to be
subject to full exchange regulation ("exempted exchanges"). The Commission
could then establish limited and narrowly tailored requirements for these
exempted exchanges. Regulation as exempted exchanges could be appropriate
for two types of alternative trading systems: (1) systems that are small,
start-up entities; and (2) systems that match or cross orders at a price
that is primarily or wholly derived from trading on another market
("passive markets"). To the extent that these types of alternative trading
systems have a sufficiently low impact on the market or do not establish
======END OF PAGE 71======
the price of securities, they should have an insignificant effect on the
market as a whole, which would not warrant exchange regulation.
At this time, all except the most significant alternative trading systems
would appear to fall within one of these two categories.
These exempted exchanges could then be subject to limited requirements
that are more appropriate than current broker-dealer regulation for the
market activities of such systems, as discussed in Section IV.B.1.c. below.
This approach also could address concerns regarding system capacity,
confidentiality, integrity, and would clarify the regulatory treatment of
alternative trading systems that fall within such a structure. Moreover,
treating smaller alternative trading systems and systems with passive
pricing mechanisms as exempted exchanges would provide an environment
conducive to innovation, which could, in turn, reduce the cost of
experimenting with innovative trading techniques.
Question 34: Are there any other categories of alternative trading
systems that have sufficiently minimal effects on the public secondary
market that they should be treated as exempted exchanges?
a. Low Impact Markets
Small alternative trading systems could be regulated as exempted
exchanges under this approach. If the Commission expands its
The integration of trading on exempted exchanges
with public trade and quote reporting mechanisms
could be accomplished by continuing to require
broker-dealer participants in exempted exchanges
to report trades to the primary market on which a
security trades and to comply with the
Commission's rules. Similarly, as a condition of
exemption, these exchanges could be required to
report trades between non-SRO member participants
to an SRO designated by the Commission.
======END OF PAGE 72======
interpretation of "exchange" to include alternative trading systems, it
would be able to exempt small markets from all exchange registration
requirements under either Section 5 or Section 36 of the Exchange Act.
Under Section 5 of the Exchange Act, the Commission has the authority
to exempt any exchange with a limited volume of transactions from
registration as a national securities exchange, provided that it is not
practicable and not necessary or appropriate in the public interest or for
the protection of investors to require registration. As noted
in the Commission's 1991 order granting an exemption to AZX under this
provision, the Exchange Act does not provide specific guidance as to the
standard to use in determining whether an exchange has a limited volume of
transactions. In considering the limited volume test, the Commission
looked to anticipated transaction volume on AZX and compared this to the
transaction volume of fully regulated national securities
exchanges. While the Commission's AZX order provides useful
guidance, the Commission also is considering other ways of assessing
whether an exchange has a limited impact on the overall market. In many
circumstances, the impact that a particular volume has on the market will
depend upon a number of factors, including the size and liquidity of the
market for the type of security traded. For example, the Commission could
use its authority under the 1996 Amendments to exempt small exchanges based
on a market's limited share of the relevant market as a whole, rather than
15 U.S.C. 78(e). In 1991, the Commission used
this authority to exempt AZX from the requirement
to register as an exchange. See AZX Exemptive
Order, supra note 24.
Id.
======END OF PAGE 73======
the number of its transactions. Similarly, the Commission could base an
exemption determination on the dollar value of transactions effected on an
exchange, or on other factors.
While an exemption would allow a new market to develop without
unnecessary and costly regulatory burdens, if that market achieved a
greater market presence, its exemption would no longer apply. Once a
market has attained more than a significant level of business, such that it
no longer can be considered to have a low impact on the securities market,
it would no longer be eligible for treatment as an exempted exchange.
Instead, it would be required to register as a national securities exchange
and be subject to greater regulatory responsibilities and oversight. In
order to give exempted exchanges that attain significant volume sufficient
time to prepare for registration as a national securities exchange, it
might be appropriate to allow exempted exchanges to delay registration as
an exchange for up to one year after they consistently attain more than de
minimis volume. Treatment of low impact markets as exempted exchanges
could also allow existing exchanges that consistently fall below minimum
volume levels for an extended period of time to deregister and instead
comply with any requirements applicable to exempted exchanges.
Question 35: Should low impact markets be regulated as exempted
exchanges, rather than as broker-dealers?
Question 36: What measure or measures should be used in determining
whether a market has a low impact? What is the level above which an
alternative trading system should not be considered to have a low
impact on the market? At what level should an already registered
exchange be able to deregister?
======END OF PAGE 74======
Question 37: Should an alternative trading system be considered to
have a low impact on the market and be treated as an exempted exchange
if it trades a significant portion of the volume of one security, even
if the trading system's overall volume is low in comparison to the
market as a whole?
Question 38: In determining whether an alternative trading system has
a low impact, what factors other than volume should the Commission
consider? Should this determination be affected if the operator of an
alternative trading system was the issuer of securities traded on that
system?
b. Passive Markets
The Commission also could treat passive markets as exempted exchanges.
Passive markets are alternative trading systems that match or cross orders
at a price that is primarily or wholly derived from trading on another
market. For example, the POSIT system allows participants to enter
unpriced orders, which other participants cannot view, and periodically
crosses the orders. Any orders that match other trading interest in this
periodic cross are executed at the mid-point of the bid/ask spread on the
primary market for the security. Like traditional exchanges, these systems
centralize orders and set the conditions under which participants agree to
trade. Unlike active pricing markets, however, passive pricing systems do
not establish the price at which securities trade on the system through the
interaction of priced orders of sellers with priced orders of buyers, or
through participant dissemination of quotes.
Question 39: Should passive markets be regulated as exempted
exchanges, rather than as broker-dealers?
======END OF PAGE 75======
c. Requirements for Exempted Exchanges
As a general matter, regardless of their regulatory status, markets
should comply with certain minimum requirements designed to clarify their
obligations as markets and to prevent harm to investors or overall market
integrity. These requirements could be less burdensome than
the broker-dealer regulation to which these markets are currently subject.
This would continue to encourage the robust development of U.S. markets.
In cases in which alternative trading systems do not also conduct customary
brokerage activities, these conditions could replace the broker-dealer
regulation to which alternative trading systems are now
subject.
Specifically, alternative trading systems seeking an exemption from
exchange registration could file an application for exemption (including a
system description) with the Commission prior to operation. The Commission
could establish a time period in which an alternative trading system's
application would automatically become effective, unless disapproved by the
The only currently exempted exchange, AZX, is
subject to a number of exemption conditions.
Among other things, it is required to provide the
Commission with regular activity reports, adopt
and implement procedures to surveil for potential
insider trading or manipulative abuses by
participants, and cooperate with the registered
SROs. See AZX Exemptive Order, supra note 24, 56
FR at 8383.
Based on the information that the Commission
currently has regarding the activities of
alternative trading systems, it believes that only
a few of the systems that would be exempted
exchanges also conduct customary brokerage
functions. Regulation of broker-dealer activities
and market activities being conducted by the same
alternative trading system could be integrated.
See infra Section IV.B.4.d.
======END OF PAGE 76======
Commission. Under this procedure, disapproval of a system's exemptive
application would probably be rare and limited to specific circumstances,
such as where a controlling person of the system is subject to a statutory
disqualification or where the system fails to meet one of the requirements
to be an exempted exchange. In addition to an initial application, an
exempted exchange could also be required to: (1) notify the Commission in
the event of a material change in operations or control; (2) maintain a
record of trading through the system and make such information available to
the Commission upon request; (3) implement procedures for surveillance of
employees' trading comparable to those adopted by existing SROs to ensure
that employees do not misuse confidential customer information for insider
or manipulative trading; (4) cooperate with registered SRO investigations
and examinations of the exempted exchange's participants; (5) report trades
to one or more designated SROs, unless a trade is reported by a trade
participant pursuant to its SRO membership obligations; and (6) require
participants to make adequate clearance and settlement arrangements prior
to participation in trading on the exempted exchange.
Question 40: Are the requirements described above appropriate to
ensure the integrity of secondary market oversight?
Question 41: Should any other requirements be imposed upon exempted
exchanges, such as requirements that an exempted exchange provide fair
access or establish procedures to ensure adequate system capacity,
integrity, and confidentiality?
Question 42: Should requirements vary with the type of alternative
trading system (e.g., should passive systems be subject to different
15 U.S.C. 78l.
======END OF PAGE 77======
conditions than systems exempted on the basis of low impact)?
Question 43: Should the Commission require that securities traded on
exempted exchanges be registered under Section 12 of the Exchange Act?
Should different disclosure standards be applicable to such securities
if they are only traded on such exchanges?
2. The Application of Exchange Regulation to Alternative
Trading Systems That Are Not Exempted Exchanges
If the term "exchange" is expanded to include alternative trading
systems, alternative trading systems that have active pricing mechanisms
and significant volume could be required to register as national securities
exchanges.
In the past, the Commission avoided requiring alternative trading
systems to register as exchanges because it had limited authority to tailor
exchange regulation to diverse market structures and because the volume and
number of alternative trading systems was relatively small. In
Throughout the past 60 years, the Commission has
attempted to accommodate market innovations within
the existing statutory framework to the extent
possible in light of investor protection concerns,
without imposing regulation that would stifle or
threaten the commercial viability of such
innovations. For example, at various times prior
to 1991, the Commission considered the
implications of evolving market conditions on
exchange regulation. See Securities Exchange Act
Release No. 8661 (Aug. 4, 1969), 34 FR 12952
(initially proposing Rule 15c2-10); Securities
Exchange Act Release No. 11673 (Sep. 23, 1975), 40
FR 45422 (withdrawing then-proposed Rule 15c2-10
and providing for registration of securities
information processors); Securities Exchange Act
Release No. 26708 (Apr. 13, 1989), 54 FR 15429
(reproposing Rule 15c2-10); and Securities
Exchange Act Release No. 33621 (Feb. 14, 1994), 59
FR 8379 (withdrawing proposed Rule 15c2-10).
======END OF PAGE 78======
particular, prior to the adoption of the 1996 Amendments, the Commission
had limited authority to reduce or eliminate the consequences of exchange
registration for innovative systems. In light of these
limitations, the Commission believed that regulating alternative trading
systems as exchanges would stifle the development of such systems.
The 1996 Amendments, however, provide the Commission with considerable
authority to exempt markets from provisions of the Exchange Act. Given
this expanded authority, the Commission's past concerns that classification
as an exchange would stifle innovation may no longer outweigh competing
Prior to adoption of the 1996 Amendments, the
Commission's authority under the Exchange Act to
reduce or eliminate negative consequences of
exchange registration was limited. For example,
the Commission could only exempt an exchange from
registration if the exchange had limited
transaction volume. See Exchange Act 5, 15 U.S.C.
78e. Once an exchange was registered, the
Commission only had authority to exempt an
exchange from a limited number of requirements
relating to an exchange's obligations as an SRO.
Although the Commission has authority under
various sections of the Exchange Act (including
Sections 17 and 19) to exempt a registered
exchange from specific provisions, its exemptive
authority under these sections relates only to an
exchange's obligations as an SRO to oversee its
members. These sections do not give the
Commission flexibility with respect to other
requirements, such as the obligation of an
exchange to file rule changes with the Commission
for approval. The Exchange Act also did not give
the Commission the flexibility or authority to
tailor regulation to reflect technological and
economic differences among markets. For example,
although Congress gave the Commission greater
flexibility to address rapidly changing market and
technological conditions when it added Section 11A
to the Exchange Act in the 1975 Amendments, that
section does not provide the Commission with
authority to reduce or eliminate existing exchange
requirements for innovative trading structures.
S. Rep. No. 75, supra note 23, at 3.
======END OF PAGE 79======
concerns regarding the need to establish a consistent, long-term approach
to the regulation of alternative trading systems and to better integrate
the most significant of these systems into the NMS.
a. Using the Commission's Exemptive Authority to Encourage
Innovation and to Eliminate Barriers to Non-Traditional
Exchanges
Alternative trading systems encompassed by a revised interpretation of
the term "exchange" and not eligible for treatment as an exempted exchange
could be subject to fundamental statutory requirements applicable to
national securities exchanges, in order to ensure that the goals of market
regulation are met. These non-traditional exchanges could be required, for
example, to file an application for registration, be organized
and have the capacity to carry out the purposes of, and comply and enforce
compliance with, the Exchange Act, the rules thereunder, and their own
rules. These non-traditional exchanges may also need to ensure that they
have rules designed to prevent fraudulent and manipulative acts and
practices, to promote just and equitable principles of trade, and to
refrain from imposing any unnecessary or inappropriate burden on
competition. In addition, they could be required to assure regulatory
Pursuant to Section 19(a)(1) of the Exchange Act,
when an applicant submits an application to
register as a national securities exchange under
Section 6 of the Exchange Act, the Commission must
publish a notice of the filing and within ninety
days must either grant the registration or
institute proceedings to determine whether the
registration should be denied. Proceedings for a
denial of registration must be concluded within
one hundred eighty days, with an extension period
available of up to another ninety days. 15 U.S.C.
78s(a)(1).
======END OF PAGE 80======
oversight of their participants, participate in national market systems,
and take the public interest into account in administering their markets.
The Commission recognizes that these responsibilities would have
significant consequences for non-traditional markets. For example,
imposing SRO oversight obligations on existing proprietary systems would
change the relationship between such systems and their participants
significantly, and could raise transaction costs for participants.
Alternative trading systems have adopted different corporate structures
than the traditional non-profit, membership exchanges and generally have
entered into primarily commercial relationships with their
participants. While expanding the common understanding of how
exchanges operate and the functions that they perform, these developing
market structures do not fit easily into the current regulatory scheme,
which has been designed and applied primarily to non-profit, membership
This effect has not been limited to U.S.
alternative trading systems. In the seven years
since the Delta Decision, see infra note 124, a
growing number of stock exchanges throughout the
world have adopted fully automated structures
similar to those of alternative trading systems
and appear to conduct trading without a specialist
or market maker structure. The Commission
determined in the Delta Release, see infra note
121, that the definition of the term exchange in
Section 3(a)(1) of the Exchange Act requires the
Commission to view an entity as an exchange only
if, in "bringing together purchasers and sellers,"
the entity performs the functions commonly
understood to be performed by exchanges. This
reading is based on the view that the words
"bringing together purchasers and sellers" in the
definition cannot be read in a vacuum, but must be
read in the context of how exchanges commonly
operate. At the time that the Delta Release was
issued, few exchanges had adopted structures
similar to alternative trading systems.
======END OF PAGE 81======
exchanges.
Prior to adoption of the 1996 Amendments, it was difficult to
reconcile the private, commercial structure of these markets with the
membership structure and public obligations traditionally assigned to
national securities exchanges under the Exchange Act. For example, one
reason the Commission has been hesitant to adopt an expansive
interpretation of the term "exchange" is that it would impose a
participant-controlled board of directors on these markets.
Applying exchange regulation to new markets could dictate their structure
and could prevent them from adopting innovative means of carrying out
exchange obligations.
There does not appear to be an overriding regulatory reason to require
markets to adopt homogenous structures. To the contrary, Congress clearly
intended the 1975 Amendments to encourage innovation by exchanges and
recognized that future exchanges may adopt diverse structures.
Accordingly, the Commission could use its exemptive authority to relieve
See Delta Release, infra note 121, at 1900. The
court in the Delta Decision stated that:
The Delta system cannot register as an
exchange because the statute requires that an
exchange be controlled by its participants,
who in turn must be registered brokers or
individuals associated with such brokers. So
all the financial institutions that trade
through the Delta system would have to
register as brokers, and [the system
sponsors] would have to turn over the
ownership and control of the system to the
institutions. The system would be kaput.
Delta Decision, infra note 124, at 1272-73.
See S. Rep. No. 75, supra note 22, at 7-9.
======END OF PAGE 82======
alternative markets from requirements it does not believe are critical to
achieving the objectives of the Exchange Act. In particular, the
Commission could permit institutions to access registered exchange
facilities directly. In addition, the Commission could consider ways in
which exchanges that are not participant-owned can meet fair representation
requirements.
(i) The Commission Could Consider Permitting
Institutional Access to Exchanges
Without exemptive relief, exchange registration would prevent
alternative trading systems from serving their institutional customers.
Historically, exchange members were individuals (and broker-dealers and
other organizations affiliated with those individuals) that traded directly
on the exchange floor and had an ownership interest in the
exchange. In keeping with this structure, many requirements
applicable to registered exchanges pertain to their relationship with their
"members." In addition, in order to give the Commission
See Special Study, supra note 4, at 11-13.
The Exchange Act defines an exchange "member" as:
The term "member" when used with respect to a
national securities exchange means (i) any natural
person permitted to effect transactions on the
floor of the exchange without the services of
another person acting as broker, (ii) any
registered broker or dealer with which such a
natural person is associated, (iii) any registered
broker or dealer permitted to designate as a
representative such a natural person, and (iv) any
other registered broker or dealer which agrees to
be regulated by such exchange and with respect to
which the exchange undertakes to enforce
compliance with the provisions of this title, the
rules and regulations thereunder, and its own
(continued...)
======END OF PAGE 83======
adequate authority over persons trading on exchanges under Section 6(c)(1)
of the Exchange Act, Congress prohibited exchanges from granting membership
to any person that is not, or is not associated with, a registered broker-
dealer. Taken together, these statutory provisions have
traditionally been interpreted to mean that all persons trading on an
exchange would be members of that exchange, and would be registered as, or
associated with, broker-dealers.
Alternative trading systems do not fit neatly into this structure for
several reasons. Unlike traditional exchanges that restrict membership to
broker-dealers, most alternative trading systems give comparable access and
(...continued)
rules.
15 U.S.C. 78c(a)(3)(A). The Commission notes that this
definition does not require an entity to participate in the
ownership of an exchange in order to be considered a
statutory "member" of that exchange.
Section 6(c)(1), 15 U.S.C. 78f(c)(1), prohibits
exchanges from granting new memberships to non-
broker-dealers. At the time this Section was
adopted in 1975, one non-broker-dealer maintained
membership on an exchange. This non-broker-dealer
was not affected by the prohibition and continues
to maintain its membership. Section 15(e) of the
Exchange Act, 15 U.S.C. 78o(e), gives the
Commission authority to require any member of a
registered exchange that is not required to
register with the Commission as a broker-dealer to
comply with any provision of the Exchange Act
(other than Section 15(a)) and rules thereunder
that regulate or prohibit any practice by a
broker-dealer.
As discussed below, however, despite this
prohibition on non-broker-dealer membership in
exchanges, Section 6(f) of the Exchange Act, 15
U.S.C. 78f(f), grants the Commission authority to
require non-broker-dealers to comply with the
rules of the exchange.
======END OF PAGE 84======
trading privileges to both institutions and broker-dealers.
If all entities that have access to an alternative trading system are
treated as "members" under the Exchange Act, Section 6(c)(1) would prevent
these systems from continuing to provide direct access to their
institutional participants. On the other hand, if institutional entities
that have access to an alternative trading system are not treated as
members, the system's statutory obligations that pertain expressly to its
"members" under the Exchange Act would not apply to those institutions, and
provisions of the Exchange Act that apply primarily to exchange members,
such as prohibitions regarding the trading of unlisted securities under
Section 12, would no longer apply to all participants on an exchange. This
could result in neither the Commission nor the market having sufficient
authority to enforce trading rules against those participants. It could
also lessen the effectiveness of oversight of trading on those markets. In
either case, if such systems were registered as exchanges, the statute's
reliance on the term "member" and the prohibition against exchange members
that are not affiliated with a broker-dealer would make it difficult for
alternative trading systems to continue meeting the trading needs of
institutional investors. The Commission also notes that, as markets
evolve, exchanges may ultimately wish to not only allow institutions to
access their trading facilities along with broker-dealers, they may wish to
Alternative markets also do not have "members" as
that term has been traditionally understood and
interpreted by existing exchanges. In particular,
most alternative markets do not give their
participants voting rights or other ownership
interests. The Commission does not consider a
non-profit membership structure to be an inherent
requirement for performing the trading functions
of an exchange.
======END OF PAGE 85======
provide trading facilities exclusively to institutions or other non-broker-
dealer participants (such as retail investors).
There is no direct evidence that Congress intended these provisions to
prohibit institutional investors from accessing the facilities of an
exchange. On the contrary, in the course of adopting the 1975 Amendments,
Congress saw no overriding regulatory reason to prohibit non-broker-dealers
from obtaining direct access to the execution facilities of
exchanges. There also does not appear to be a regulatory
need to require entities to register as broker-dealers in order to obtain
direct access to exchanges. Because institutions primarily
In the legislative history of the 1975 Amendments,
Congress expressly noted that advances in
communication technologies could permit an entity
to trade on an exchange without the services of a
member acting as a broker, and without itself
becoming a member of that exchange. Reports by
both the House of Representatives Committee on
Interstate and Foreign Commerce and the Senate
Committee on Banking, Housing and Urban Affairs
noted the potential for technology to permit non-
members (both broker-dealers and institutions) to
effect transactions on exchanges without the
intermediation of a broker. See S. Rep. No. 75,
supra note 22, at 99 (1975) ("The Committee
recognizes that it is impossible at this time to
define precisely the manner in which investors,
particularly large institutional investors will or
should have access to execution facilities in a
national market system."); H.R. Rep. No. 123,
supra note 39, at 66 ("[I]t is conceivable, that
the regulatory reach could be extended to
investors or money managers who are not themselves
brokers or dealers but who have been permitted the
means of making direct executions on an
exchange").
See, e.g., Securities Exchange Act Release No.
35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 1994)
(order approving Chicago Match, an electronic
matching system operated by the CHX, which
(continued...)
======END OF PAGE 86======
trade for their own account, do not execute orders for unaffiliated
customers, and do not undertake to maintain orderly markets for the
exchange, institutional trading on an exchange does not necessarily raise
the type of concerns that broker-dealer regulation was designed to
address.
Congress did, however, provide the Commission and exchanges with
sufficient authority in such circumstances to oversee the trading of non-
(...continued)
provided for the crossing of orders entered by CHX
members and non-members, including institutional
customers).
For example, expanding the Commission's
interpretation of what constitutes an exchange to
include alternative trading systems with
institutional participants could subject such
institutions to the constraints of Section 11(a)
of the Exchange Act. Section 11(a) generally
prohibits exchange members from effecting
transactions on such exchanges for their own
accounts or the accounts of their associated
persons, or for their own managed accounts or the
managed accounts of their associated persons. 15
U.S.C. 78k(a). Section 11(a) was intended to
encourage fair dealing and fair access in the
exchange markets by restricting exchange members'
proprietary trading, which Congress believed
created a conflict between a member's interests as
a principal and the member's fiduciary obligations
when representing customer trades. Both Congress
and the Commission provided exceptions to the rule
to accommodate principal trading that does not
conflict with the public interest.
Section 11(a) also granted the Commission broad authority to
regulate exchange members' trading. Congress explained that
it gave the Commission broad authority under Section 11(a)
for two reasons. First, Congress recognized that it lacked
expertise in this area, and thus believed that any doubts
should be resolved in favor of maintaining present business
practices. Second, Congress wanted the Commission to have
sufficient flexibility to accomplish the purposes of the
Exchange Act. See S. Rep. No. 75, supra note 22, at 68.
======END OF PAGE 87======
members on exchanges. Section 6(f) of the Exchange Act authorizes the
Commission to require any non-member that is effecting transactions on an
exchange without the services of another person acting as broker to comply
with the rules of such exchange. In addition, any person
required by the Commission to comply with an exchange's rules pursuant to
Section 6(f) would be deemed a "member" of such exchange for most relevant
provisions of the Exchange Act. Congress therefore
15 U.S.C. 78f(f)(1).
Section 3(a)(3)(A) of the Exchange Act provides
that: "For purposes of sections 6(b)(1), 6(b)(4),
6(b)(6), 6(b)(7), 6(d), 17(d), 19(d), 19(e),
19(g), 19(h), and 21 of this title, the term
'member' when used with respect to a national
securities exchange also means, to the extent of
the rules of the exchange specified by the
Commission, any person required by the Commission
to comply with such rules pursuant to section 6(f)
of this title." 15 U.S.C. 78c(a)(3)(A). This
would require a registered exchange that permitted
institutions to effect transactions without the
services of a broker, among other things, to: (1)
enforce compliance by such institutions with the
provisions of the Exchange Act, the rules and
regulations thereunder, and the rules of the
exchange; (2) allocate equitably its dues, fees,
and other charges among its members, issuers, and
such institutions; and (3) provide fair procedures
for the disciplining of such institutions.
Exchange Act 6(b)(1), (4), (7) and 19(g), 15
U.S.C. 78f(b)(1), (4), (7), and 19(g). Further,
an exchange imposing any disciplinary sanction on,
denying participation to, or prohibiting or
limiting access to any institution would be
required to file notice of such action with the
Commission. The Commission would have authority
to review any such action. Exchange Act 19(d) and
19(e), 15 U.S.C. 78s(d) and 78s(e). The
Commission would have the same authority to
allocate among SROs regulatory responsibilities
with respect to institutions effecting
transactions on an exchange without the services
of a broker as it currently does with respect to
(continued...)
======END OF PAGE 88======
envisioned that it would be possible to allow entities to have electronic
access to an exchange without becoming a member, and at the same time, to
ensure through Section 6(f) that the exchange and the Commission have
adequate authority to regulate such electronic access participants.
The development of fully automated markets has revealed an
inconsistency in this scheme, however. Both the Commission and Congress
have recognized that the "floor" of an exchange could include a non-
physical trading system operated by such exchange. As a
result, any natural person with direct access to an exchange's alternative
trading system would appear to be effecting transactions on the "floor" of
such exchange and, therefore, would be a "member" of that exchange under
the statute. Despite congressional intent not to unnecessarily restrict
non-member access to exchanges under this interpretation, there would
appear to be no circumstances in which institutions could electronically
access an automated exchange without being considered "members" of that
(...continued)
exchange members. Exchange Act 17(d), 15 U.S.C.
78q(d). The Commission would also have the
authority to sanction an exchange for failure to
enforce compliance with the Exchange Act, the
rules thereunder, or the exchange's rules by
institutions that were permitted to effect
transactions on the exchange, and to commence an
investigation under Section 21 to determine
whether any such institution has violated the
Exchange Act. Exchange Act 21, 15 U.S.C. 78u.
See Committee on Interstate and Foreign Commerce
Report, H.R. Rep. No. 123, supra note 39, at 66
(1975) ("As the market systems make greater use of
communications and data processing techniques, the
concept of a physical 'floor' of an exchange will
disappear. Instead we will have a communications
network which will serve as the 'floor' of the
future marketplace").
======END OF PAGE 89======
exchange.
In order to make it possible for alternative markets to register as
exchanges, therefore, congressional intent to allow entities to have access
to exchanges without becoming traditional members must be reconciled with
the existence of non-physical "floors." Any method of doing so must also
ensure that, as Congress intended, exchanges and the Commission have
sufficient authority to supervise and oversee all persons accessing an
exchange's facilities.
There are at least two ways in which the Commission could achieve
this. First, the Commission could interpret the term "member" narrowly, to
apply only to natural persons who are permitted to effect transactions on a
physical exchange floor. Under this interpretation, no
entity that accesses a fully automated exchange would be deemed a "member"
of that exchange. In addition, both broker-dealers and institutions could
electronically access exchanges that maintain physical floors without being
deemed members of those exchanges. With respect to any such non-member
participants on an exchange, the Commission could exercise its authority
under Section 6(f) of the Exchange Act to require the non-member
participants of an exchange to comply with that exchange's rules to the
extent appropriate. In addition, these non-member participants could be
deemed members of such exchanges for certain purposes of the Exchange Act.
Depending upon the extent to which the Commission exercised its authority
under Section 6(f), therefore, there may be little practical difference in
Persons trading on the physical floor of an
exchange, such as floor brokers and specialists,
would continue to be "members" of that exchange
under any construction of the Exchange Act.
======END OF PAGE 90======
an exchange's obligations to surveil traditional members and its obligation
to surveil entities that are members by virtue of a Commission order
pursuant to Section 6(f).
In the alternative, the Commission could interpret the term "member"
broadly, to apply to any natural persons that are permitted to effect
transactions through an exchange's facilities and any persons associated
with such natural persons. Under this interpretation, the Commission could
then use the exemptive authority granted by the 1996 Amendments to exempt
exchanges from the prohibition on non-broker-dealer membership in Section
6(c)(1) of the Exchange Act. The Commission could then allow exchanges to
revise any rules that would not appropriately apply to non-broker-dealer
members. Using this approach, the Commission would not be called upon to
exercise its authority under Section 6(f).
Question 44: Should the Commission allow institutions to be
participants on registered exchanges to the same extent as registered
broker-dealers? If so, should the Commission adopt rules allowing
registered exchanges to have institutional participants, or should the
Commission issue exemptive orders on a case-by-case basis, upon
application for relief by registered exchanges?
Question 45: Should the Commission allow exchanges to provide
services exclusively to institutions?
Question 46: If the Commission allows institutions to participate in
In these circumstances, it is not clear how
provisions of the Exchange Act that are by their
terms applicable only to exchange members or
broker-dealers would apply to non-broker-dealers
that access exchange facilities. For example,
Sections 11(a) and 9(b) would not appear to apply
directly to non-member participants in exchanges.
======END OF PAGE 91======
exchange trading, should the Commission view all entities that have
electronic access to exchange facilities as "members" under the
Exchange Act and then exempt exchanges from Section 6(c)(1)?
Question 47: Is it foreseeable that exchanges will wish to permit
retail investors to be participants in their markets? If so, should
the Commission allow retail participation on registered exchanges to
the same extent as registered broker-dealers?
Question 48: Should the Commission allow registered exchanges to
provide services exclusively to retail investors?
Question 49: Could exchanges have various classes of participants, as
long as admission criteria and means of access are applied and
allocated fairly? Would it be in the public interest if new or
existing exchanges sought to operate primarily or exclusively on a
retail basis? What would be the advantages and disadvantages if new
or existing exchanges were to admit as participants only highly
capitalized institutions or only highly capitalized institutions and
broker-dealers?
(ii) The Commission Could Consider Ways in Which
Alternative Exchanges Can Meet Fair Representation
Requirements
An exchange's obligation to establish fair representation of investors
and participants in its decisionmaking process could also significantly
affect the structure of proprietary systems. Section 6(b)(3) of the
Exchange Act compels an exchange to have rules that: (1) provide that one
or more directors is representative of issuers and investors, and not
associated with a member of the exchange, or with any broker-dealer; and
======END OF PAGE 92======
(2) "assure a fair representation of its members in the selection of its
directors and administration of its affairs." Securities
associations have identical fair representation requirements.
Because many alternative trading systems are operated as for-profit, non-
membership corporations, complying with these representation obligations
would potentially change the nature of their operations and relationship
with their participants.
With respect to the first requirement, the public's interest in
ensuring the fairness and stability of significant markets was of paramount
importance to Congress, which adopted a structure that seeks to ensure this
through public representation on an exchange's board of directors. Under
this structure, fair representation of the public on an oversight body that
has substantive authority and decisionmaking ability therefore may be
critical to ensure that an exchange actively works to protect the public
interest and that no single group of investors has the ability to
systematically disadvantage other market participants through use of the
exchange governance process.
The second requirement, that of fair representation of an exchange's
members, also serves to ensure that an exchange is administered in a way
that is equitable to all market members and participants. Because a
registered exchange is not solely a commercial enterprise, but also has
significant regulatory powers with respect to its members,
Exchange Act 6(b)(3), 15 U.S.C. 78f(b)(3).
Exchange Act 15A(b)(4), 15 U.S.C. 78o-3(b)(4).
See NASD 21a Report, supra note 20.
See supra Section II.B.1.
======END OF PAGE 93======
competition between exchanges may not be sufficient to ensure that an
exchange carries out its regulatory responsibilities in an equitable
manner. The fair application of an exchange's authority to bring and
adjudicate disciplinary procedures may be particularly important in this
respect, because these actions can have significant and far-reaching
ramifications for broker-dealers. Accordingly, under the Exchange Act
structure, it may be essential to give exchange participants equitable and
enforceable input into disciplinary and other key processes to prevent them
from being conducted in an inequitable, discriminatory, or otherwise
inappropriate fashion.
The Commission has not, however, interpreted an exchange's obligation
to provide fair representation of its members to mean that all members must
have equal rights. Instead, the Commission has allowed registered SROs a
degree of flexibility in complying with this requirement. For example,
Pacific Exchange "electronic access members" ("ASAP Members") do not have
voting rights, and therefore are not represented on the board of that
exchange. In addition, with respect to clearing agencies,
the Commission has stated that registered clearing agencies may employ
several methods to comply with the fair representation
standard. Other structures may also provide independent,
See Securities Exchange Act Release No. 28335
(Aug. 13, 1990), 55 FR 34106 (Aug. 21, 1990)
(order approving rule change establishing
electronic access memberships on the PSE, since
renamed PCX).
These methods include: (1) solicitation of board
of directors nominations from all participants;
(2) selection of candidates for election to the
board of directors by a nominating committee which
(continued...)
======END OF PAGE 94======
fair representation for an exchange's constituencies in its material
decisionmaking processes, for exchanges that are not owned by their
participants. For example, an alternative trading system that registers as
an exchange might be able to fulfill this requirement by establishing an
independent subsidiary that has final, binding responsibility for bringing
and adjudicating disciplinary proceedings and rule making processes for the
exchange, and ensuring that the governance of such subsidiary equitably
represents the exchange's participants.
Question 50: Should non-membership exchanges (including alternative
trading systems that may register as exchanges) be exempt from fair
representation requirements?
Question 51: Should all exchanges be required to comply with Section
6(b)(3) by having a board of directors that includes participant
representation?
Question 52: If not, are there alternative structures that would
(...continued)
would be composed of, and selected by, the
participants or representatives chosen by
participants; (3) direct participation by
participants in the election of directors through
the allocation of voting stock to all participants
based on their usage of the clearing agency; or
(4) selection by participants of a slate of
nominees for which stockholders of the clearing
agency would be required to vote their share. See
Securities Exchange Act Release No. 14531 at 24
(March 6, 1978), 43 FR 10288 (March 10, 1978).
See also Securities Exchange Act Release No. 16900
(June 17, 1980), 45 FR 41920 (June 23, 1980).
The Commission notes that the proprietary exchange
Easdaq, a recognized secondary market in Belgium,
has established a "regulatory authority" that has
a degree of independence from Easdaq's board of
directors.
======END OF PAGE 95======
provide independent, fair representation for all of an exchange's
constituencies (including the public)?
3. Expanding the Commission's Interpretation of "Exchange"
To create a new category of exempted exchanges and to apply exchange
registration requirements to the most significant alternative trading
systems, the Commission would have to expand its current interpretation of
"exchange" to encompass many more trading systems than are currently
considered "exchanges." Although the Exchange Act definition of "exchange"
is potentially quite broad, the Commission currently
interprets this definition to include only those organizations that are
"designed, whether through trading rules, operational procedures or
business incentives, to centralize trading and provide buy and sell
quotations on a regular or continuous basis so that purchasers and sellers
have a reasonable expectation that they can regularly execute their orders
at those price quotations." The Commission analyzed how the
definition of exchange applies to alternative trading systems in a 1991
release, explaining its decision not to register a government options
The Exchange Act defines an "exchange" as:
any organization, association, or group of persons,
whether incorporated or unincorporated, which
constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers
of securities or for otherwise performing with respect
to securities the functions commonly performed by a
stock exchange as that term is generally understood,
and includes the market place and the market facilities
maintained by such exchange.
U.S.C. 78c(a)(1).
See Securities Exchange Act Release No. 27611
(Jan. 12, 1990), 55 FR 1890, 1900 (Jan. 19, 1990).
======END OF PAGE 96======
trading system as an exchange ("Delta Release"). The
Commission concluded that, in light of congressional emphasis on the
"generally understood" meaning of stock exchange and the Exchange Act as a
whole, the definition of exchange should be applied narrowly, to include
only those entities that enhanced liquidity in traditional ways through
market makers, specialists, or a single price auction
structure. Because most alternative trading systems do not
Id. In 1988, the Commission granted Delta
Government Options Corporation ("Delta") temporary
registration as a clearing agency to allow it to
issue, clear, and settle options executed through
a trading system operated by RMJ Securities
("RMJ"). Concurrently, the Commission's Division
of Market Regulation issued a letter stating that
the Division would not recommend enforcement
action against RMJ if its system did not register
as a national securities exchange. Subsequently,
the Board of Trade of the City of Chicago and the
Chicago Mercantile Exchange petitioned the U.S.
Court of Appeals for the Seventh Circuit for
review of the Commission's actions. Both
challenges were premised on the view that RMJ's
system unlawfully failed to register as an
exchange or obtain an exemption from registration.
The Seventh Circuit vacated Delta's temporary
registration as a clearing agency, pending
publication of a reasoned Commission analysis of
whether or not RMJ's system was an exchange within
the meaning of the Exchange Act. Board of Trade
v. SEC, 883 F.2d 525 (7th Cir. 1989). In 1989,
the Commission solicited comment on the issue, and
in 1990 published its interpretation of the term
"exchange" and its determination that RMJ's system
did not meet that interpretation. See Delta
Release, supra note 121.
See Delta Release, supra note 121, at 1900. The
Commission stated:
In summary, employing an expansive interpretation
of Section 3(a)(1) results in potential conflicts
with other central regulatory definitions under
the [Exchange] Act as well as adverse effects on
(continued...)
======END OF PAGE 97======
have these features, this narrow interpretation effectively excluded most
alternative trading systems from exchange regulation. Thus,
(...continued)
innovation and competition. Rather, each system
must be analyzed in light of the statutory
objectives and the particular facts and
circumstances of that system. In conducting such
an analysis, the central focus of the Commission's
inquiry should be whether the system is designed,
whether through trading rules, operational
procedures or business incentives, to centralize
trading and provide buy and sell quotations on a
regular or continuous basis so that purchasers and
sellers have a reasonable expectation that they
can regularly execute their orders at those price
quotations. The means employed may be varied,
ranging from a physical floor or trading system
(where orders can be centralized and executed) to
other means of intermediation (such as a formal
market making system or systemic procedures such
as a consolidated limit order book or regular
single price auction).
Id.
The Commission's authority to adopt this narrow
interpretation was subsequently upheld by the U.S.
Court of Appeals for the Seventh Circuit. Board
of Trade of the City of Chicago v. SEC, 923 F.2d
1270 (7th Cir. 1991), reh'g en banc, den'd, (7th
Cir. 1991) (hereinafter Delta Decision). The
court noted that "the Delta system differs only in
degree and detail from an exchange . . . Section
3(a)(1) [of the Exchange Act] is broadly worded.
No doubt . . . this was to give the Securities and
Exchange Commission maximum control over the
securities industry. So the Commission could have
interpreted the section to embrace the Delta
system. But we do not think it was compelled to
do so." Id. at 1273 (quoting Chevron v. Natural
Resources Defense Council, 467 U.S. 837, 844-45
(1984)). In reaching its decision, the court gave
weight to the Commission's belief that classifying
the Delta system as an exchange would have
destroyed its commercial viability. The court
also relied in part on the Commission's position
that, because Delta would be registered as a
clearing agency and the system sponsor would be a
(continued...)
======END OF PAGE 98======
many alternative trading systems have not been required to register as
exchanges to date and have instead been regulated as broker-dealers.
There are, however, several alternative ways in which the definition
of "exchange" could be applied more broadly. For example, a
(...continued)
registered broker-dealer, there did not appear to
be any overriding regulatory need to regulate the
system as an exchange. Delta Decision, supra at
1273. The court stated that the Commission "can
determine . . . whether the protection of
investors and other interests within the range of
the statute is advanced, or retarded, by placing
the Delta system in a classification that will
destroy a promising competitive innovation in the
trading of securities." Id. Since 1991, the
Commission staff has given operators of trading
systems assurances, based on the interpretation
upheld by the court in Delta, that it would not
recommend enforcement action if those systems
operated without registering as exchanges. For a
list of no-action letters issued to system
sponsors until the end of 1993 and a short history
of the Commission's oversight of such systems, see
Securities Exchange Act Release No. 33605 (Feb.
14, 1994), 59 FR 8368, 8369-71 (Feb. 18, 1994)
(hereinafter Rule 17a-23 Proposing Release). See
also Letters from the Division of Market
Regulation to: Niphix Investments Inc. (Dec. 19,
1996); Tradebook (Dec. 3, 1996); The Institutional
Real Estate Clearinghouse System (May 28, 1996);
Chicago Board Brokerage, Inc. and Clearing
Corporation for Options and Securities (Dec. 13,
1995).
The Exchange Act, coupled with relevant
legislative history, appears to provide the
Commission with ample authority to revise its
interpretation of an exchange. Courts have
consistently upheld an agency's discretion to
revise earlier interpretations when a revision is
reasonably warranted by changed circumstances.
See, e.g., Rust v. Sullivan, 500 U.S. 173, 186
(1991). In Rust, the Court stated that "an
initial agency interpretation is not instantly
carved in stone, and the agency, to engage in
informed rulemaking, must consider varying
(continued...)
======END OF PAGE 99======
large variety of services performed by existing markets and intermediaries
could be considered to be functions that are commonly understood to be
performed by exchanges within the meaning of Section 3(a)(1) of the
Exchange Act. Those services include: (1) centralizing trading interest;
(2) providing the opportunity for multiple parties to participate in
trading; (3) specifying time, price, size, or other priorities governing
the sequence or interaction of orders; (4) providing an opportunity for
active price formation (either through interaction of buy and sell interest
or through competing dealer quotes); (5) specifying material conditions
under which participants may post quotations or trading interest (such as
requiring participants to maintain firm, two-sided, or continuous quotes);
(6) creating mechanisms for enhancing liquidity, such as giving certain
participants special privileges in exchange for assuming market
obligations; (7) giving participants control over setting the trading
rules; and (8) setting qualitative standards for listing instruments or
otherwise standardizing the material terms of instruments traded. Various
commenters have identified these and other functions as central
(...continued)
interpretations and the wisdom of its policy on a
continuing basis. Id. at 186 (quoting Chevron v.
Natural Resources Defense Council, 467 U.S. 837,
844-45 (1984)). The Court also stated that "an
agency is not required to 'establish rules of
conduct to last forever,' but rather 'must be
given ample latitude to adapt its rules and
policies to the demands of changing
circumstances.'" Id. at 186-87 (quoting Motor
Vehicles Mfrs. Ass'n of United States v. State
Farm Mut. Automobile Ins. Co., 463 U.S. 29, 42
(1983)).
======END OF PAGE 100======
characteristics of exchanges.
See, e.g., Robert A. Schwartz, Technology's Impact
on the Equity Markets (Future Markets: How
Information Technology Shapes Competition (C.
Kremerer ed., forthcoming 1997)) ("In the U.S., an
exchange is an environment where broker/dealer
intermediaries, not natural buyers and sellers
meet. In contrast, broker/dealer member firms
provide the services (information analysis and
dissemination, provision of dealer capital, order
handling, account handling etc.) that bring the
customer to the market to trade."); Ruben Lee,
What is an Exchange? (1992) (available from
author) (regulators should consider 25 attributes
when determining whether a trading system is an
exchange, including price discovery, liquidity,
competition of orders, price priority, secondary
priorities, information access, and centralized
order execution); Therese Maynard, What is an
"Exchange"?-Proprietary Electronic Securities
Trading Systems and the Statutory Definition of an
Exchange, 49 Wash. & Lee L. Rev. 833 (1991); J.
Harold Mulherin et al, Prices are Property: The
Organization of Financial Exchanges from a
Transaction Cost Perspective, 34 J. of Law & Econ.
591 (Oct. 1991) (the establishment of property
rights to price quotes is a central function of
financial exchanges, although the authors do not
discount the fact that exchanges accomplish many
other functions); Lawrence Harris, Liquidity,
Trading Rules, and Electronic Trading Systems
(1990) (available from author) (exchanges provide
services by creating an environment that
encourages traders to offer liquidity, often by
establishing a set of rules that provide liquidity
suppliers protection in proportion to the service
that they provide to the market); Jonathan Macey &
Hideki Kanda, The Stock Exchange as a Firm: The
Emergence of Close Substitutes for the New York
and Tokyo Stock Exchanges, 75 Cornell L. Rev. 1007
(1990) (in addition to liquidity, organized stock
exchanges offer three other services (monitoring,
devising standard form contracts, and lending
reputational capital to listing firms) that
listing firms view as valuable); Ian Domowitz, An
Exchange is a Many Splendored Thing: The
Classification and Regulation of Automated Trading
Systems, in The Industrial Organization and
Regulation of the Securities Industry 93 (Andrew
(continued...)
======END OF PAGE 101======
Each of these functions is performed by existing exchanges and could
be incorporated into the Commission's interpretation of the term
"exchange." Because alternative trading systems do not
always offer each of these services, however, if alternative trading
systems are integrated into market regulation mechanisms through exchange
regulation, a revised interpretation of the term "exchange" based on
whether a market offers all, or many, of these functions would continue to
exclude many alterative trading systems. For example, the application of
the term exchange could be broadened to include those entities that provide
the opportunity for multiple parties to participate in centralized trading.
While many alternative trading systems provide a central execution system,
others organize trading by centralizing the display of participant trading
interest, and then specifying the sequence or priorities under which
participants must trade with each other. Although orders may not directly
(...continued)
W. Lo ed., 1996) (the price discovery process with
the associated dissemination of price information,
and centralization for the purpose of trade
execution are the basic functions of trading
systems). See also Ruben Lee & Ian Domowitz,The
Legal Basis for Stock Exchanges: The
Classification and Regulation of Automated Trading
Systems (1996) (available from authors) (there
should be no distinction in the regulation of
market structure issues between institutions now
classified as exchanges and those now classified
as broker-operated trading systems).
For example, as noted above, the Commission's
current interpretation captures the functions of
centralizing trading interest, providing the
opportunity for multiple parties to participate in
trading, and providing mechanisms to enhance
liquidity, such as giving certain participants
special privileges in return for assuming market
obligations.
======END OF PAGE 102======
interact on such markets, the order and price at which they are executed is
determined by the market. The fairness of this procedure will affect
participants in those markets no less than the fairness of procedures on an
exchange that allows orders to interact centrally.
Similarly, an exchange could be defined as only those entities that
provide an opportunity for active price formation (either through
interaction of buy and sell interest or through competing dealer quotes).
This criteria would capture automated matching systems, such as Instinet,
Tradebook, Island and Terra Nova's Archipelago system, but would not
include crossing systems that establish a price based on the price already
established in another market, such as POSIT, within the term "exchange."
Whether or not a market engages in active price formation, however, is not
the sole factor that may determine a market's potential to harm investors
through unfair treatment or vulnerability to manipulation. Moreover,
markets without active price discovery still have the potential to affect
the integrity of trading and surveillance on other markets. Depending upon
its configuration, for example, a passive pricing system can provide
incentives for its participants to manipulate prices in the market from
which the passive price is derived in order to affect the outcome of a
cross. Finally, while there is general consensus that active price
formation occurs through the interaction of orders, there is little
consensus on whether the interaction of orders through negotiation, such as
occurs within a broker-dealer, should also be considered to be price
formation. As market changes continue to affect how
Compare Lawrence A. Cunningham, From Random Walks
to Chaotic Crashes: The Linear Genealogy of the
(continued...)
======END OF PAGE 103======
securities trade, basing the interpretation of the term "exchange" on
whether a market engages in price discovery could generate significant
uncertainties for markets that develop innovative pricing
mechanisms. Therefore, if the Commission expands its
interpretation of the term "exchange," it could be appropriate to include
passive markets in such an interpretation. Under such an approach, passive
markets could be integrated into market regulation by regulating such
systems as exempted exchanges.
Reinterpreting the term "exchange" based on other traditional exchange
functions may have similar drawbacks. For example, unlike existing
exchanges, few alternative markets give certain participants special
privileges in return for assuming market obligations, give participants
control over setting the trading rules, or set listing
(...continued)
Efficient Capital Market Hypothesis, 52 Geo. Wash.
L. Rev. 546, 597 (1994) ("price discovery in
capital markets arises solely as the result of
traders' orders meeting in the market"); with M.
Perry,A Challenge Postponed: Market 2000
Complacency in Response to Regulatory Competition
for International Equity Markets, 34 Va. J. Int'l
L. 701, 740 (1994) ("It is not clear whether
'price discovery' means price negotiation between
the trading parties or price determination by the
market").
For example, one trading system currently in
development, OptiMark, allows participants to
enter entire portfolios of securities at a range
of prices and sizes at which they would be willing
to trade if a variety of other factors are met.
It is not clear whether this type of contingent
pricing mechanism could be considered "active
price formation."
======END OF PAGE 104======
standards. Moreover, while many exchanges currently provide
the services noted above, it is not certain that exchanges will always do
so in the future. As a result, if alternative trading
systems were integrated into market regulation through exchange regulation,
rather than broker-dealer regulation, basing a revised interpretation of
"exchange" on these traditional functions could result in the same
regulatory gaps and lack of flexibility that the current situation has
created.
For these reasons, if the Commission were to revise its interpretation
of "exchange," it would also consider focusing such a reinterpretation
primarily on those essential functions commonly provided by registered
exchanges and alternative markets, in order to achieve congressional intent
to regulate central marketplaces for securities trading. For example, the
Commission could revise its interpretation of the term "exchange" to
Although many alternative trading systems limit
trading to securities traded on a registered
exchange or Nasdaq, they do not establish or
enforce qualitative or quantitative independent
listing standards or require that securities be
registered under the Exchange Act.
See, e.g., Gerald Novak, A Failure of
Communications: An Argument for the Closing of the
NYSE Floor, 26 U. Mich. J.L. Reform 485, 503
(1993) (while specialists may create enough
benefit to the market to allow them to exist
within the current regime, the benefits do not
seem substantial enough to maintain the physical
exchanges solely for the purpose of perpetuating
the role of the specialist.) See also Norman S.
Poser, Restructuring the Stock Markets: A Critical
Look at the SEC's National Market System, 56
N.Y.U.L. Rev. 883, 956-57 (1981) (arguing for the
elimination of the present specialist system in
favor of an institutionalized specialist
function).
======END OF PAGE 105======
include any organization that both: (1) consolidates orders
of multiple parties; and (2) provides a facility through which, or sets
material conditions under which, participants entering such orders may
agree to the terms of a trade. This revised interpretation would closely
reflect the statutory concept of "bringing together" buying and selling
interests. It would also broaden the Commission's concept of what is
"generally understood" to be an exchange to reflect changes in the U.S. and
world markets brought about by automated trading.
Question 53: Would the revised interpretation of "exchange" being
considered by the Commission adequately and clearly include
alternative trading systems that operate open limit order execution
systems (even those that also provide brokerage functions)?
Question 54: In light of the decreasing differentiation between
As noted above, the term "orders" in this release
is intended to be read broadly, to include any
firm trading interest. This would include both
limit orders and market maker quotations.
See, e.g., AZX Exemptive Order, supra note 24;
Internet Site of the Australian Stock Exchange,
address: http://www.azx.com.au (Dec. 5, 1996)
(orders entered on the Australian Stock Exchange
are automatically matched and executed through
SEATS, a screen based trading system); Internet
Site of SIMEX, address: http://www.simex.com
(Nov. 6, 1996) (the Singapore International
Monetary Exchange is a complete, integrated
electronic trading system, which uses an order
matching system based upon the use of a matching
algorithm reflecting strict price/time priority
for all orders entered into the system). In
addition, Tradepoint, a recognized investment
exchange in the United Kingdom, operates as an
order driven, automated system for the trading of
shares of U.K. issuers listed on the London Stock
Exchange without the use of market makers or
specialists.
======END OF PAGE 106======
market maker quotes and customer orders in trading, should the
Commission consider an "order" to include any firm trading interest,
including both limit orders and market maker quotes?
Question 55: What should the Commission consider to be "material
conditions" under which participants entering orders may agree to the
terms of a trade? For example, should an alternative trading system
be considered to be setting "material conditions" when it standardizes
the material terms of instruments traded on the market, such as
standardizing option terms or requiring participants that display
quotes to execute orders for a minimum size or to give priority to
certain types of orders?
a. Effects of Expanding the Commission's Interpretation of
"Exchange" on Selected Types of Alternative Trading
Systems
One of the principal advantages of expanding the Commission's
interpretation of the term "exchange" would be to provide sufficient
flexibility within the concept of an exchange to encompass both currently
registered exchanges and significant existing alternative trading systems,
as well as unforeseen alternative trading systems that may arise in the
future. At the same time, the Commission has consistently maintained that
the definition of exchange should not be interpreted so broadly as to
overlap or interfere with other sections of the Exchange Act, such as those
governing broker-dealer activities or securities associations. For
example, at the time of the Delta Release, the Commission sought to avoid
interpreting the term "exchange" in a way that could unintentionally and
======END OF PAGE 107======
inappropriately subject many broker-dealers to exchange
regulation. Therefore, if the Commission decides to broaden
its interpretation of "exchange" to encompass alternative trading systems,
it would have to take into account the potential effects of such an
interpretation on entities regulated under other sections of the Exchange
Act. This may include entities that provide traditional brokerage
activities (e.g., traditional block trading desks or internal programs that
allow traders within a firm to search and match orders with customer orders
of other traders within the same firm), information vendors, and markets
operated by the NASD. For example, the Commission would not intend any
revised interpretation of "exchange" to capture traditional brokerage
activities or the internal automation of traditional brokerage activities.
Similarly, it may be inappropriate for a revised interpretation of
"exchange" to capture certain alternative trading systems, such as
interdealer brokers in exempted securities, that are regulated under
separate regulatory schemes. Discussed below are the possible effects of
an expanded interpretation of "exchange" on these market participants.
(i) Broker-Dealer Activities
In light of the blurring distinctions between the services offered by
One key factor in the Commission's decision not to
regulate the Delta system as an exchange was the
concern that, absent greater exemptive authority,
doing so would subject traditional broker-dealer
activities to exchange regulation. Delta Release,
supra note 121. Although some alternative trading
systems claim to be the modern analog of
traditional brokerage activity, the Commission
believes that, while some are, the nature of
systems that combine the functions of brokers and
exchanges cannot be so readily simplified.
======END OF PAGE 108======
markets and market participants described above, the
differences between modern exchange and broker-dealer activities are not
easily articulated. Some firms have integrated technology into their
activities in ways that appear to have much in common with the trading
systems used by modern exchanges. Nonetheless, broker-dealer activities
can be distinguished from those of an exchange for several reasons.
First, unlike organized markets, traditional broker-dealer activities
do not involve the systematic interaction of customer orders where the
customers themselves are informed of and have an opportunity to agree to
the terms of their trades (or agree to the priorities under which the terms
will be set). For example, broker-dealers may automate part of their
intermediary function (such as block trading desk activity) by developing
internal programs that allow traders within a firm to search and match
orders with customer orders of other traders within the same firm, or with
orders and quotes of other traders. Similarly, technologically
sophisticated firms may create an internal process for centralizing
information regarding customer orders. Such systems, however, generally
serve as a means of providing information regarding a firm's customer
orders solely to the employees of the broker-dealer operating the system to
facilitate the employees' crossing of customer orders on a discretionary
basis. In other words, the only participant in such a system is the
broker-dealer that operates it. Similarly, while block trading desks
provide a central location where employees of a single broker-dealer trade
side-by-side, they do not systematically consolidate the customer orders
handled by those employees. Although an employee may ultimately match its
See supra notes 14 and 14 and accompanying text.
======END OF PAGE 109======
customer order with a customer order held by a trader sitting across the
room, this does not operate as an organized mechanism for ensuring that
customer orders are matched, crossed, or otherwise centralized.
Second, a broker-dealer traditionally retains discretion in
determining how to handle customer orders. Unlike an exchange, which
customers access in part to participate in a particular market or market
structure, a customer that gives its order to a broker-dealer typically
gives discretion to that broker-dealer regarding which market the order
will ultimately be executed in, how the order may be split up or "worked,"
or whether the broker-dealer will choose to execute the order as principal
or as agent. Although a broker-dealer may disclose its standard practices
to customers, ultimately these execution decisions are left to the
discretion of the broker-dealer, consistent with the responsibilities
imposed on broker-dealers. For example, a block positioner may "shop" the
order around to other traders in his own firm in an attempt to find a
contra-side order that has been placed with another trader. In some cases,
the block positioner may take the other side of the order, keeping the
block as a proprietary position. This decision is dictated by market
conditions and typically lies within the block positioner's discretion.
Unless otherwise agreed, customers have no rights regarding the system
other than the expectation that the broker-dealer will handle the order
according to its broker-dealer obligations.
Finally, a sophisticated market maker that develops a system to
broadcast its own quotations to the public, or to allow its customers to
direct orders for execution solely against that market maker's inventory,
is conducting broker-dealer activity. Such systems automate the order
======END OF PAGE 110======
routing and execution mechanisms of a single market maker and guarantee
that the market maker will execute orders submitted to it at its own posted
quotation for the security or, for example, at the inside price quoted on
Nasdaq. Single market maker systems merely provide a more efficient means
of communicating the trading interest of separate customers to one dealer
and thus would not be considered exchange activities.
As noted above, much of this analysis assumes that these activities
are being engaged in "systematically," or in a "traditional" or "typical"
fashion. The Commission recognizes that these concepts are not easily
defined and that this approach will leave many issues and gray areas to be
resolved. The Commission is soliciting comment on how any revised
interpretation of the term exchange could clearly distinguish between these
activities and those of alternative trading systems.
Question 56: Is it appropriate for the Commission to consider the
activities described above as broker-dealer activities?
Question 57: How should a revised interpretation of exchange
adequately and clearly distinguish broker-dealer activities, such as
block trading and internal execution systems, from market activities?
Question 58: Are the distinctions discussed above accurate
reflections of exchange and broker-dealer activities? Are there other
factors that may better distinguish a broker-dealer from an exchange?
(ii) Organized Dealer Markets
The term "exchange," as articulated above, would encompass organized
dealer markets that operate systems to consolidate participant orders for
display, and set material conditions under which orders can be executed
======END OF PAGE 111======
(including automatically executing orders). As discussed in
the Delta Release, dealer markets have traditionally consisted of loosely
organized groups of individual dealers that trade securities OTC, without
formal consolidation of orders or trading. Historically, the majority of
trading in corporate, government, and municipal debt instruments has been
conducted through such OTC dealers. Individual dealers in such markets
generally do not directly "bring together" public purchasers and sellers.
The court and the parties in the Delta Decision assumed that
the term "exchange," as that term is generally understood, would not apply
to such a loosely organized market. The approaches described above
continue the notion that the definition of "exchange" should not cover such
loosely organized traditional dealer markets and that broker-dealer
regulation should continue to govern individual dealers in those
markets. As individual dealers and associations of dealers
The only dealer market in the United States that
currently appears to both consolidate participant
quotes and set conditions governing execution is
the Nasdaq market, operated by the NASD. As
discussed below, because the NASD is already
registered as a securities association, the
Commission would not intend for any revised
interpretation of "exchange" to include the Nasdaq
market. The Commission, however, could consider
whether other entities that operate similar
markets in the United States should be considered
exchanges under any expanded interpretation,
unless they were also operated by a registered
securities association.
See Delta Decision, supra note 124.
For example, commercial paper trades through
several large dealers that disseminate their own
quotes to their customers and make a two-sided
market in the paper of various issuers. Trading
in the commercial paper market is highly
(continued...)
======END OF PAGE 112======
have employed technology to make OTC markets more efficient, however,
dealer markets in certain instruments have become organized to such an
extent that they have assumed many of the characteristics of exchange
markets. This is particularly true in markets that trade instruments that
are also listed on registered exchanges, such as equity securities. For
example, Nasdaq consolidates trading interest of multiple dealers on a
screen that is displayed real-time to its members, and provides a mechanism
for dealers to update displayed quotations. The NASD also imposes
obligations on market makers in Nasdaq National Market and SmallCap
securities to provide a continuous source of liquidity in Nasdaq,
establishes minimum qualifications that issuers must meet in order for
their securities to be quoted on the consolidated screen, and sets
enforceable rules that govern the priorities dealers must give to certain
orders. Through additional services, such as SelectNet, Nasdaq also allows
dealers to trade with orders electronically. In other words, a group of
market participants, through Nasdaq, act in concert to centralize and
disseminate trading interest and establish the basic rules by which
securities will be traded on Nasdaq. Because the NASD is already
registered as a securities association, the Nasdaq market would not need to
be regulated as an exchange. The Commission, however, could consider
whether entities that operate similar markets in the United States should
(...continued)
concentrated among a few large dealers, some of
which provide automated quotation screens for
their customers. Unlike an exchange market,
however, no entity currently attempts to
centralize trading interest by reflecting multiple
dealer quotes, or by setting conditions under
which the commercial paper of differing issuers
may be traded by dealers.
======END OF PAGE 113======
be considered exchanges under any expanded interpretation if they are not
operated by a registered securities association.
Question 59: How should a revised interpretation of the term
"exchange" adequately and clearly distinguish broker-dealer
activities, such as block trading and internal execution systems, from
market activities?
Question 60: What factors should the Commission consider in
determining whether an organization of dealers is sufficiently
"organized" to require exchange registration?
(iii) Information Vendors and Bulletin Boards
The Commission is also concerned that any revised interpretation of
the term "exchange" not be so broad as to encompass those entities that
provide information, but do not provide a central facility for executing
trades or set conditions governing trading. Information vendors and
"bulletin boards" often provide a centralized display of general trading
interest, comments, or other information regarding trading, but they
generally do not enable customers to communicate directly with each other,
execute orders, or otherwise agree to the terms of a trade through their
facilities. These entities also do not establish the conditions under
which customers negotiate or trade based on displayed
information. Because these entities centralize information
Commission staff has previously indicated that it
would not recommend enforcement action if a system
operated by an issuer that does not allow
transactions to be executed on the system, and
that is designed to provide limited information to
buyers and sellers of stock, does not register as
an exchange. See Letter from Catherine McGuire,
Martin Dunn, and Jack Murphy, SEC, to Barry Reder,
(continued...)
======END OF PAGE 114======
without standardizing trading based on such information, the approach
described above would not regulate these entities as exchanges if they do
not allow for execution through their system or set conditions of trading.
The Commission recognizes that the difference between an exchange and
an electronic bulletin board depends on the functions that they make
available. For instance, a passive bulletin board that merely provides
names and addresses of prospective buyers and sellers and the prices at
which they are willing to buy or sell would not be an exchange because it
would not set priorities that govern trades, and transactions resulting
from posted indications of interest, if any, would be executed outside the
system. If a system created an electronic link between multiple potential
buyers (e.g., a "chat room"), however, it could be considered to be
providing a facility through which participants entering orders may agree
to the terms of a trade (e.g., an exchange). The Commission requests
comment on whether such a system should be considered to be an exchange,
particularly if the customer orders displayed on the system are firm, or if
the system specifies the priorities for customer interaction through the
electronic linkage or "chat room."
Question 61: Does the revised interpretation of "exchange" described
(...continued)
Coblentz, Cahen, McCabe & Breyer, LLP (June 24,
1996) (counsel to Real Goods Trading Corporation).
In addition, it is possible for an information
vendor to provide its services by linking its
screens to execution facilities provided by other
entities with which the vendor has a contractual
arrangement. In these circumstances, the
information vendor may be captured by the proposed
revised interpretation of the term "exchange,"
depending upon the nature of the services
provided.
======END OF PAGE 115======
above clearly exclude information vendors, bulletin boards, and other
entities whose activities are limited to the provision of trading
information? How should the Commission distinguish between
information vendors, bulletin boards, and exchanges?
(iv) Interdealer Brokers
Certain markets that are not centrally organized by a single entity
are nonetheless informally organized around interdealer
brokers, which display the bids and offers of other dealers
anonymously. The importance and role of these interdealer brokers has
changed significantly in the past twenty years. While interdealer brokers
traditionally had relatively small volume, they are now key players in the
government and municipal securities markets, and have begun
to operate in other instruments as well. Today, interdealer brokers
provide liquidity by providing a central mechanism to display the bids and
As used in this release, the term "interdealer
brokers" includes entities that are referred to as
brokers' brokers and blind brokers in certain
markets.
Trading by interdealer brokers began to become
popular in the government securities market, after
trading had moved from the NYSE to the over-the-
counter market in the 1920s and the demise of
trading agreements in the mid-1950s that had
previously provided a foundation for interdealer
business. See U.S. Congress, Joint Economic
Committee, A Study of the Dealer Market for
Federal Government Securities 21-26, 49-53 (1960);
U.S. Department of the Treasury and U.S. Federal
Reserve, Treasury-Federal Reserve Study of the
Government Securities Markets 95-100 (1959). By
1972, interdealer brokers handled approximately
14% of the trading of government securities by
dealers; by 1990, interdealer brokers handled more
than 50% of such business. See Marcia Stigum, The
Money Market 644-56 (3d ed. 1990).
======END OF PAGE 116======
offers of multiple dealers and by allowing dealers and investors to trade
large volumes of securities anonymously and efficiently based on those bids
and offers. In the government securities market, for example, interdealer
brokers compile and display the anonymous bids and offers of other
government securities dealers and traders on screens located in the
dealers' offices. Dealers call an interdealer broker via telephone to
display their quote information or to execute against a displayed
quotation. Automated brokers' brokers in the secondary
Dealers and other customers have direct telephone
lines to the various individual brokers working at
an interdealer broker. The individual brokers
typically handle one to three customers each,
depending upon activity levels. When customers
wish to buy or sell a security through an
interdealer broker, they call the individual
broker assigned to them at that interdealer
broker. Through their assigned broker, customers
can hit a bid or take an offer already shown on
the screen, tell the broker to post a new, better
bid or offer on the screen, or give the broker
other information about their activities and
trading needs. When customers wish to hit a quote
on the screen or enter a new quote, the broker
taking that information announces the hit or new
bid/offer to other brokers (who are taking
information from other customers), and the broker
or other staff enter the information so that it is
displayed on internal and customer screens.
Trading supervisors within the interdealer broker
mediate disputes, such as which broker called out
an order first. See generally U.S. DEPARTMENT OF
THE TREASURY, REPORT OF THE SECRETARY OF THE
TREASURY ON SPECIALIZED GOVERNMENT SECURITIES
BROKERS AND DEALERS (1995) (hereinafter 1995
TREASURY REPORT); U.S. SECURITIES AND EXCHANGE
COMMISSION, 1994 ANNUAL REPORT 29-30 (1994); U.S.
DEPARTMENT OF THE TREASURY, U.S. SECURITIES AND
EXCHANGE COMMISSION, AND BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM, JOINT REPORT ON THE
GOVERNMENT SECURITIES MARKET 26 (1992)
(hereinafter 1992 JOINT REPORT); STIGUM, supra
note 142; U.S. GENERAL ACCOUNTING OFFICE, U.S.
(continued...)
======END OF PAGE 117======
market for municipal securities operate in a similar manner, disseminating
centralized quotation information and executing trades for their customers
by telephone.
Operating in this manner, interdealer brokers centralize trading
interest and provide a mechanism for agreeing to the terms of a trade in
much the same way as registered exchanges and alternative markets do.
Interdealer brokers in these markets may also determine certain trading
practices. This is a significant change from the way
interdealer brokers operated just 30 years ago, when they disseminated last
(...continued)
GOVERNMENT SECURITIES: MORE TRANSACTION
INFORMATION AND INVESTOR PROTECTION ARE NEEDED,
19, 97-100 (1990); U.S. GENERAL ACCOUNTING
OFFICE, U.S. GOVERNMENT SECURITIES: AN
EXAMINATION OF VIEWS EXPRESSED ABOUT ACCESS TO
BROKERS' SERVICES 28-35 (1987).
See Division of Market Regulation, U.S. Securities
and Exchange Commission, Staff Report on the
Municipal Securities Market 17-22 (1993)
(hereinafter Municipal Securities Report). See
also Securities Exchange Act Release No. 37998
(Nov. 29, 1996), 61 FR 64782 (Dec. 6, 1996)
(Commission approval order for Municipal
Securities Rulemaking Board proposals to increase
transparency in the municipal securities market);
U.S. Securities and Exchange Commission, 1995
Annual Report 31 (1995).
Generally, a broker considers a bid or offer
placed with it good until canceled, but the
conditions under which they are subject to
variation is a matter left up to each interdealer
broker. For example, usually, "when the [Federal
Reserve] comes into the market, all bids and
offers [become subject to reaffirmation].
However, when some key economic number is
released, some brokers make the market [subject to
reaffirmation], others don't; in this area, there
are no formal rules." Stigum, supra note 142, at
647.
======END OF PAGE 118======
sale information to customers individually, rather than centrally, and
operated under less formalized procedures.
Like block trading desks, interdealer brokers now have certain
elements in common with markets, but have also retained some of their
traditional characteristics. For example, although interdealer brokers do
not give advice, they exercise some discretion in matching and executing
orders of their dealer customers. Commenters have suggested
that these features should distinguish traditional interdealer brokers to
some extent from markets that establish priorities for executing
participant orders or that otherwise set conditions governing trading
between participants. Because interdealer brokers have begun to display
quotations in real-time to their customers, centralize the negotiation of
trading, and establish conventions under which trading will occur, the
issue is whether this difference has become primarily one of
degree. Individual brokers at an interdealer broker, in many
respects, perform similar functions to exchange specialists. Moreover, if
an interdealer broker automated its activities fully, there would appear to
be little difference between its activities and those of existing
See 1992 Joint Report, supra note 143, at A9-A11.
"The government brokers run what amounts to an
unlicensed exchange. In the 20-odd years that
governments have been brokered, the way in which
that exchange operates has slowly changed. At the
outset, brokers phoned runs to dealers, then in
1977 to 1978, the era of screens began." Stigum,
supra note 142, at 655. The following quote from
a dealer also supports the Commission's view:
"Also, dealers came to view the brokers as just
one more place, along with the Chicago pits, to
trade -- just another place to get business done."
Id. at 652.
======END OF PAGE 119======
alternative trading systems. Given this evolution, the Commission could
consider whether interdealer brokers should be considered exchanges under a
revised interpretation.
If the Commission determines that the activities of interdealer
brokers should be encompassed by a revised interpretation of "exchange," it
could consider whether to use its exemptive authority to exclude those
interdealer brokers that trade exempted securities from
exchange registration requirements. As noted in the Delta Release,
Congress has given no indication that it intended to subject traditional
interdealer brokers in the government and municipal securities markets to
exchange regulation. Moreover, regulation of traditional
interdealer brokers in government and municipal securities as exchanges may
not be necessary or appropriate in the public interest at this time, in
light of the specialized oversight structures for these markets. Both the
government and municipal securities markets are overseen through special
regulatory schemes that are tailored to the particular features of those
debt markets. Government securities broker-dealers are overseen jointly by
the U.S. Department of the Treasury ("Treasury"), the Commission, and
federal banking regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the federal
Exempted securities are defined in Section
3(a)(12) of the Exchange Act to include government
securities and municipal securities, among other
things. 15 U.S.C. 78c(a)(12).
See Delta Release, supra note 121, at 1898 n.87.
======END OF PAGE 120======
banking laws. Municipal securities broker-dealers and
transactions in municipal securities are overseen by the Commission, the
Municipal Securities Rulemaking Board ("MSRB"), the NASD, and the federal
banking regulatory authorities under the Exchange Act (particularly Section
15B) and the federal banking laws. Unlike equities and other instruments
traded primarily on registered exchanges, surveillance of
trading in government and municipal securities is not conducted by entities
that operate competing markets in those instruments. Instead, surveillance
of the government securities market is coordinated among the Treasury, the
See 1995 Treasury Report, supra note 143.
Under the regulatory structure established by the
Government Securities Act of 1986, as amended in 1993,
the Treasury was given rulemaking authority over all
brokers and dealers in government securities.
Specifically, the Treasury was designated by Congress
as the sole rulemaker for specialized government
securities brokers and dealers (33 firms as of March
1995) and was given rulemaking authority for the
government securities activities of financial
institutions that filed notice as government securities
brokers and dealers (approximately 300 as of January
1995). The Treasury and the SEC have overlapping
rulemaking responsibilities for the government
securities activities conducted by general securities
brokers and dealers (15(b) firms) which numbered about
2,231 as of March 1995. The [Government Securities
Act] granted the Treasury the authority to promulgate
rules and regulations for each of these entities
concerning financial responsibility, protection of
investor securities and funds, recordkeeping and
financial reporting, and audits.
Id. at 3.
Although all marketable Treasury notes, bonds, and
zero-coupon securities are listed on the NYSE,
exchange trading volume is a small fraction of the
total over-the-counter volume in these
instruments. See 1992 Joint Report, supra note
143.
======END OF PAGE 121======
Commission, and the Board of Governors of the Federal Reserve System. In
the municipal securities market, Congress established the MSRB as an SRO
for broker-dealers in municipal securities; unlike SROs in other markets,
however, the MSRB does not operate a market and was not given inspection or
enforcement powers. Surveillance of the municipal securities market for
fraud and market manipulation is conducted by the Commission and the
NASD.
As a result of these specialized oversight structures, regulation of
particular market participants in the government and municipal securities
markets as broker-dealers, rather than as exchanges, is not likely to
weaken coordination of overall market oversight or create competitive
inequities among differently regulated entities that perform similar
functions. For these reasons, if the Commission expands its interpretation
of "exchange" to cover interdealer brokers generally, it could consider
expressly exempting traditional government and municipal securities
Coordinated surveillance of secondary trading in
municipal securities is still developing. The
MSRB, under the Commission's supervision, has
authority to issue rules governing, among other
things, professional qualifications,
recordkeeping, quotations, and advertising of
municipal securities broker-dealers. Enforcement
of MSRB rules is divided between banking
regulatory agencies (for banks) and the NASD (for
non-bank firms), with the Commission having
authority over all municipal securities dealers,
as well as non-bank municipal securities broker-
dealers. See Municipal Securities Report, supra
note 144, at 37. Recently, the Commission
approved an MSRB rule change designed to increase
the information available about municipal
securities and to provide a centralized audit
trail of municipal securities transactions. See
Securities Exchange Act Release No. 37998 (Nov.
29, 1996), 61 FR 64782 (Dec. 6, 1996).
======END OF PAGE 122======
interdealer brokers that trade exempted securities from exchange
registration.
It should be noted that the above analysis is based on existing
mechanisms for supervising trading in government and municipal securities
markets, and on current trading practices of interdealer brokers in such
markets. In the event that an interdealer broker automates its services
more completely, or operates in a manner more similar to an equity market,
for example, this analysis could be reevaluated. Similarly, the above
analysis would not apply to derivatives of government and municipal
securities.
Question 62: If the Commission expands its interpretation of
"exchange," should the Commission exempt interdealer brokers that deal
only in exempted securities from the application of exchange
registration and other requirements?
Question 63: How could the Commission define interdealer brokers in a
way that would implement congressional intent not to regulate
traditional interdealer brokers as exchanges, without unintentionally
exempting other alternative trading systems operated by brokers?
4. Effect of Broadening the Definition of "Exchange"
Reinterpreting the definition of "exchange" to apply to a broader
range of entities would have significant effects, not only on those
alternative trading systems classified as exchanges, but also on the
securities trading on those exchanges, currently registered exchanges, the
NMS, clearance and settlement mechanisms, and market participants. In
particular, substantial work would be necessary to ensure that newly
registered exchanges could be smoothly integrated into existing market
======END OF PAGE 123======
structures.
a. Regulation of Securities Trading on Alternative Trading
Systems
Classifying alternative trading systems as exchanges could affect the
trading of securities on these systems, particularly on those systems that
are required to register as national securities exchanges. Securities
traded on a national securities exchange must be registered with the
Commission and approved for listing on the exchange, or traded pursuant to
Commission regulations governing trading of securities listed on another
exchange ("unlisted trading privileges" or "UTP"). These requirements are
critical to ensuring that securities trading on exchanges provide investors
with adequate information and that all relevant trading activity in a
security is reported to, and surveilled by, the exchange on which such
security is listed.
Specifically, Section 12(a) of the Exchange Act makes it unlawful for
any member, broker, or dealer to effect any transaction in any security
(other than an exempted security) on a national securities exchange unless
a registration statement is in effect as to such security for such exchange
in accordance with the provisions of the Exchange Act and the rules and
regulations thereunder. Under this requirement, upon
registration as exchanges, alternative trading systems that are currently
trading unregistered securities could no longer freely trade those
15 U.S.C. 78l(a). Section 12(b), 15 U.S.C.
78l(b), contains procedures for the registration
of securities on a national securities exchange.
======END OF PAGE 124======
securities.
In addition, national securities exchanges are permitted to trade
securities listed on other exchanges and Nasdaq only pursuant to UTP
regulations, which limit the range of securities that they may
trade. Like all exchanges, a newly registered exchange would
be required to have in place rules for trading the class or type of
securities it seeks to trade. To trade Nasdaq/National
Market ("NM") securities, a newly registered exchange would also be
required to become a signatory to an existing plan governing such
trading. Moreover, under Section 12(f) of the Exchange Act,
exchanges cannot trade securities not registered on an exchange or
classified as NM securities (such as Nasdaq SmallCap or other OTC
securities) without Commission action. Section 12(f) of the Exchange Act
authorizes the Commission to permit the extension of UTP to any security
registered otherwise than on an exchange. The OTC-UTP plan,
which permits UTP for Nasdaq/NM securities, is the only extension approved
Section 12(a) does not apply to exchanges that the
Commission has exempted from registration as
national securities exchanges, although the
Commission could consider whether it would be
appropriate to limit trading on exempted exchanges
to securities registered under Section 12 of the
Exchange Act. See AZX Exemptive Order, supra note
24. See also Securities Exchange Act Release No.
37271 (June 3, 1996), 61 FR 29145 (June 7, 1996).
Exchange Act 12(f), 15 U.S.C. 78l(f).
Exchange Act Rule 12f-5, 17 CFR 240.12f-5.
See OTC-UTP plan, infra note 168.
See infra note 168 and accompanying text.
======END OF PAGE 125======
to date by the Commission. Thus, exchanges cannot currently
trade Nasdaq SmallCap, other OTC securities, or exempted securities that
are not separately listed on the exchange. This restriction would also
apply, absent Commission action, to alternative trading systems newly
registered as exchanges.
These restrictions would have a significant effect on newly registered
exchanges. Most alternative trading systems do not independently list
securities; securities traded on such systems are generally unlisted or
listed on another market. As a result, in order to comply with Exchange
Act requirements applicable to national securities exchanges, such systems
would need to establish listing procedures and comply with Commission
regulations governing unlisted trading privileges. Under the tiered
approach to regulating alternative trading systems, the ability of such
systems to trade a wide range of securities would be subject to the same
UTP conditions as currently registered exchanges. In order to minimize
some of these effects, the Commission could consider expanding the category
of securities that would be available for UTP trading.
Integrating a broader range of entities into the UTP structure could
Id.
National securities exchanges are also prohibited,
pursuant to Exchange Act Rule 12f-2, from
extending UTP to a security subject to an initial
public offering ("IPO") until the trading day
following commencement of the IPO. Currently,
pursuant to NASD rules, participants in the OTC
market, including alternative trading systems, may
trade securities subject to an IPO immediately
after trading has opened on the listing exchange.
NASD Manual Section 6440(j). If registered as an
exchange, such entities would be subject to the
one-day waiting period prior to trading securities
subject to an IPO.
======END OF PAGE 126======
also affect existing exchange rules, such as NYSE Rule 390 and similar
offboard trading restrictions, designed to limit members from effecting OTC
transactions in exchange-listed stocks. For example,
transactions that are executed through alternative trading systems
currently may be considered to be OTC transactions. If significant
alternative trading systems were to register as exchanges, activity on
those systems could no longer be considered to be OTC. Consequently, rules
that expressly prohibit OTC transactions in listed securities by their
terms would no longer apply to activity on those alternative trading
systems and, as a result, the number of transactions subject to the
prohibition of such rules would decrease. The Commission is soliciting
comment on whether there would be any customer protection or competitive
reasons to preserve these offboard trading restrictions if the
interpretation of "exchange" is broadened to include alternative trading
systems and highly organized dealer markets.
Question 64: How could the Commission foster the continued trading of
all securities currently traded on alternative trading systems if
these systems are classified as exchanges under the interpretation
described above and some of these systems are required to register as
national securities exchanges? For example, what would be the effect
For example, NYSE Rule 390 prohibits NYSE members
from effecting certain transactions in NYSE-listed
stocks in the OTC market. Exchange Act Rule 19c-
1, however, prohibits the application of off-board
trading restrictions to trades effected by a
member as agent. 17 CFR 240.19c-1. Moreover,
Exchange Act Rule 19c-3 prohibits the application
of off-board trading restrictions to securities
listed on an exchange after April 26, 1979. 17 CFR
240.19c-3.
======END OF PAGE 127======
on alternative trading systems that wish to trade securities exempted
from registration under Rule 144A if those systems are required to
register as national securities exchanges?
Question 65: How would the requirement to have rules in place for
trading unlisted securities affect the viability of alternative
trading systems that are required to register as national securities
exchanges?
Question 66: Would the specifications in the OTC-UTP plan relating to
the trading of Nasdaq/NM securities pose particular problems for
systems that are required to register as national securities
exchanges?
Question 67: Should the Commission extend UTP to securities other than
NM securities, such as Nasdaq SmallCap securities? What effect would
an inability to trade Nasdaq SmallCap and other non-Nasdaq/NM
securities have upon alternative trading systems that are required to
register as national securities exchanges?
Question 68: What effect would the prohibition on UTP trading of
newly listed stock until the day following an initial public offering
have upon systems that are required to register as national securities
exchanges?
Question 69: How should existing exchange rules designed to limit
members from effecting OTC transactions in exchange-listed stock be
applied, if the Commission's interpretation of exchange were expanded
to include alternative trading systems and organized dealer markets?
What customer protection and competitive reasons might there be to
preserve these rules if alternative trading systems are classified as
======END OF PAGE 128======
exchanges?
b. Integration with National Market System Mechanisms and
Existing Exchange Practices
A revised interpretation of the term "exchange" would not only affect
currently registered exchanges and alternative trading systems required to
register as exchanges, it could also have a significant impact on the NMS,
coordination of market-wide trading policies, listing arrangements, and
exchange rules governing member trading in the OTC market. There could
also be significant effects on coordination of market-wide surveillance and
enforcement efforts among national securities exchanges.
Because alternative trading systems differ in several key respects
from currently registered exchanges, a number of issues would need to be
resolved before these systems could be integrated into national market
system mechanisms. Integrating newly registered national securities
exchanges into the NMS mechanisms should not cause the homogenizing of all
markets - to the contrary, it is as important today as it was in 1975 to
cultivate an atmosphere in which innovation is welcome and possible. Such
integration therefore could require revision of NMS mechanisms so that they
could accommodate diverse and evolving markets. The Commission solicits
comment, as discussed in greater detail below, on what revisions to the
structure of NMS mechanisms might be necessary to accommodate alternative
trading systems. The Commission also solicits comment on the costs and
potential effects on innovation if alternative trading systems were linked
to NMS mechanisms. In addition, the Commission solicits comment on the
costs and potential effects if revisions to the NMS mechanisms were not
effective.
======END OF PAGE 129======
Question 70: What effects would linking alternative trading systems
to NMS mechanisms have on those systems? For example, how would such
linkages affect the ability of alternative trading systems to operate
with trading and fee structures that differ from those of existing
exchanges or to alter their structures? To what extent could revision
of the NMS plans alleviate these effects?
(i) Inter-Market Plans
If certain alternative trading systems were required to register as
national securities exchanges, these systems would be expected to become
participants in market-wide plans currently subscribed to and operated by
registered exchanges and the NASD. All of the currently registered
exchanges and the NASD participate in joint plans for transaction and
quotation reporting: the CQS, the CTA, the ITS, the Options
The CTA provides vendors and other subscribers
(including alternative trading systems) with
consolidated last sale information for stocks
admitted to dealings on any exchange. The CQS
gathers quotations from all market makers in
exchange-listed securities and disseminates them
to vendors and other subscribers. The ITS is a
communications system designed to facilitate
trading among competing markets by providing each
market participating in the ITS pursuant to a plan
approved by the Commission ("ITS plan") with order
routing capabilities based on current quotation
information. See, e.g., Securities Exchange Act
Release Nos. 37191 (May 9, 1996), 61 FR 24842 (May
16, 1996); 17532 (Feb. 10, 1981), 46 FR 12919
(Feb. 18, 1981); 23365 (June 23, 1986), 51 FR
23865 (July 1, 1986) (Cincinnati Stock Exchange /
ITS linkage); 18713 (May 6, 1982) 47 FR 20413 (May
12, 1982) (NASD's CAES / ITS linkage); 28874 (Feb.
12, 1991), 56 FR 6889 (Feb. 20, 1991) (Chicago
Board Options Exchange / ITS linkage).
======END OF PAGE 130======
Price Reporting Authority ("OPRA"), and the Nasdaq/National
Market System/Unlisted Trading Privileges ("OTC-UTP"). These
plans form an integral part of the NMS for the trading of securities, and
contribute greatly to the operation of linked, transparent, efficient, and
fair markets. In order for any newly registered national securities
exchanges to become fully integrated into the NMS, it would be essential
that the operations of those new exchanges and the market linkage systems
be compatible. If the Commission revises its approach to regulation of
alternative trading systems by requiring those with active pricing
mechanisms and significant volume to register as national securities
exchanges, it may have to take action to ensure the suitable and timely
inclusion of new exchanges into the NMS.
(A) Quotation and Transacting Reporting
If certain alternative trading systems are required to register as
national securities exchanges, they would be required to have effective
quote and transaction reporting plans and procedures in place under Section
11A of the Exchange Act. The CTA and CQS plans, which are
now operated by the eight national securities exchanges and the NASD, make
quote and transaction information in exchange-listed securities available
to the public. Both the CTA and the CQS plans have provisions governing
See infra note 169 and accompanying text for a
description of the OPRA plan.
See infra note 168 and accompanying text for a
description of the OTC-UTP plan.
See also Exchange Act Rules 11Ac1-1(b)(1), 17 CFR
240.11Ac1-1(b)(1); 11Aa3-2(c), 17 CFR 240.11Aa3-
2(c).
======END OF PAGE 131======
the entry of participants to the plans. According to the
terms of the CTA plan, any national securities exchange or registered
national securities association may become a participant of the CTA by
subscribing to the CTA plan and paying to the existing
participants an appropriate amount for the "tangible and intangible assets"
created under the plans that will be made available to the new participant.
The CQS Plan has similar terms. Participants in the CTA and CQS plans
share in the income and expenses associated with the provision of quotation
information according to the terms of the plans.
Under the terms of the OTC-UTP plan governing trading of Nasdaq/NMS
securities, any national securities exchange where Nasdaq/NMS
securities are traded may become a full participant thereunder. The plan
The CTA plan also contains a provision for
entities other than participants to report
directly to the CTA as "other reporting parties."
Pursuant to this provision, parties other than a
national securities exchange or association may be
permitted to provide transaction data directly to
the CTA.
See Securities Exchange Act Release No. 37191 (May
9, 1996), 61 FR 24842 (May 16, 1996).
See Joint Self-Regulatory Organization Plan
Governing the Collection, Consolidation and
Dissemination of Quotation and Transaction
Information for Exchange-listed Nasdaq/National
Market System Securities and for Nasdaq/National
Market System Securities Traded on Exchanges on an
Unlisted Trading Privilege Basis ("OTC-UTP plan").
Securities Exchange Act Release No. 24407 (Apr.
29, 1987), 52 FR 17349 (May 7, 1987). Currently,
the NASD, the CHX, and the Phlx are participants
in the OTC-UTP plan. The BSE is a limited
participant, and as such only reports quotation
and transaction information for Nasdaq/NM
securities that are also listed on the BSE. See
Securities Exchange Act Release No. 36985, 61 FR
12122 (March 18, 1996).
======END OF PAGE 132======
specifically states that a new signatory must pay a share of development
costs to become a participant in the plan. The plan provides for the
collection, consolidation, and dissemination of quotation and transaction
information for Nasdaq/NM securities, sets forth specifications for
transmission of data to Nasdaq, and establishes procedures for market
access, regulatory trading halts, cost allocation, and revenue sharing.
Similarly, the OPRA plan approved by the Commission provides
for the collection and dissemination of last sale and quotation information
on options that are traded on the participant exchanges. Under the terms
of the plan, any national securities exchange whose rules governing the
trading of standardized options have been approved by the Commission may
become a party to the OPRA plan. The plan provides that any new party, as
a condition of becoming a party, must pay a share of OPRA's start-up costs.
It also provides for revenue sharing among all parties.
Given the breadth of these plans, existing plan participants would
need to work expeditiously with newly registered exchanges to facilitate
inclusion of these new exchanges into the NMS plans. Participation in
these transaction reporting plans should not seriously impair the
functioning of most alternative trading systems. If the Commission revised
its approach to regulation of alternative trading systems by requiring
those with active pricing mechanisms and high volume to register as
national securities exchanges, it may have to take action to ensure the
The OPRA plan was approved pursuant to Section 11A
of the Exchange Act and Rule 11a3-2 thereunder.
See Securities Exchange Act Release No. 17638
(Mar. 18, 1981) (hereinafter OPRA plan). The five
exchanges which are participants in the OPRA plan
are the Amex, the CBOE, the NYSE, the PCX, and the
Phlx.
======END OF PAGE 133======
suitable and timely inclusion of new exchanges into these quotation and
transaction reporting plans.
Question 71: Are there any insurmountable technical barriers to
admission of alternative trading systems into the CTA, CQS, OPRA, or
OTC-UTP plans?
Question 72: What costs are associated with the admission of new
applicants to these plans?
Question 73: Are there any CTA, CQS, OPRA, or OTC-UTP plan rules that
would prevent newly registered national securities exchanges from
obtaining fair and equal representation on these entities?
Question 74: What effect would the admission of newly registered
national securities exchanges to the CTA, CQS, OPRA, and OTC-UTP plans
have upon the governance and administration of those plans?
Question 75: Do admissions fees for new participants required by the
terms of the plans present a barrier to admission to the plans? Do
the plans' provisions that all participants are eligible to share in
the revenues generated through the sale of data affect commenters'
views on this issue?
(B) Intermarket Trading System
It has been the Commission's longstanding policy that market centers
trading listed stocks be linked. The current linkage, ITS, enables a
broker or dealer who participates in one market to execute orders, as
principal or agent, in an ITS security at another market center, by sending
a commitment to execute with another market through the system. ITS also
establishes a procedure that allows specialists to solicit pre-opening
interest in a security from specialists and market makers in other markets,
======END OF PAGE 134======
thereby allowing these specialists and market makers to participate in the
opening transaction. Participation in an opening transaction can be
especially important when the price of a security has changed since the
previous close. Finally, ITS rules require that the members of participant
markets avoid initiating a purchase or sale at a worse price than that
available on another ITS participant market ("trade-
throughs"). Participation in the ITS will give users of
these new exchanges full access to, and enable them to execute transactions
on other ITS participant markets. Moreover, participation in ITS will
require new exchanges to comply with other applicable ITS rules and
policies on matters such as, for example, trade- throughs, locked
markets, and block trades.
A trade-through occurs when an ITS participant
purchases securities at a lower price or sells at
a higher price than that available in another ITS
participant market. For example, if the NYSE is
displaying a bid of 20 and an offer of 20 1/8 for
an ITS security, the prohibition on trade-throughs
would prohibit another ITS participant market from
buying that security from a customer at 19 7/8 or
selling that security to a customer at 20 1/2.
See ITS plan, supra note 162, at Exhibit B. In
addition, each participant market has in place
rules to implement the ITS Trade-Through Rule.
See, e.g., NASD Rule 5262. The plan also provides
a mechanism for satisfying a market aggrieved by
another market's trade-through. See ITS plan,
supra note 162, at Exhibit B(b)(2).
A locked market occurs when an ITS participant
disseminates a bid for an ITS security at a price
that equals or exceeds the price of the offer for
the security from another ITS participant or
disseminates an offer for an ITS security at a
price that equals or is less than the price of the
bid for the security from another ITS participant.
The plan provides a mechanism for resolving locked
markets.
======END OF PAGE 135======
Under an approach that involved broadening the interpretation of
"exchange," entities newly registered as national securities exchanges
would be expected to sign the plan and become participants in ITS, or an
equivalent system if one were developed. Alternative trading
systems, however, have developed differently than exchanges and often serve
different constituencies. Some practices of alternative trading systems
would undoubtedly conflict with the current provisions of the ITS plan, or
would be incompatible with participation in ITS. For example, many
alternative trading systems allow participants to trade in smaller
increments than those available on current plan participants. Similarly,
many alternative trading systems have institutional participants who may
prefer to trade at an inferior price in order to trade in a larger size,
resulting in a locked or crossed market. These characteristics are
potentially incompatible with current ITS provisions. If the Commission
were to adopt a revised approach to the regulation of alternative trading
systems, it likely would be necessary to work with plan participants to
accommodate diverse market structures in the plan.
Question 76: What effect would the admission of new, highly automated
(...continued)
The ITS block trade policy provides that the
member who represents a block size order shall, at
the time of execution of the block trade, send or
cause to be sent, through ITS to each
participating ITS market center displaying a bid
(or offer) superior to the execution price a
commitment to trade at the execution price and for
the number of shares displayed with that market
center's better priced bid (or offer).
To become a participant in ITS, an exchange or
association must subscribe to, and agree to comply
and to enforce compliance with, the provisions of
the plan. See ITS plan, supra note 162, at
section 3(c).
======END OF PAGE 136======
participants have upon the operation of the ITS?
Question 77: How would compliance with the current ITS rules and
policies affect trading on alternative systems that may be regulated
as exchanges? How appropriate are these rules and policies for
alternative trading systems?
Question 78: What costs would be associated with newly registered
exchanges joining ITS? Would those costs represent a barrier for newly
registered exchanges to join ITS?
Question 79: Are there any ITS plan rules or practices that would
prevent newly registered national securities exchanges from obtaining
fair and equal representation on the ITS?
Question 80: What effect would the admission of newly registered
national securities exchanges to the ITS plan have upon the governance
and administration of the plan?
(ii) Uniform Trading Standards
The Commission is also considering how policies governing market-wide
trading, such as trading halts and circuit breakers, would apply to
alternative trading systems that register as exchanges. Registered
national securities exchanges, the NASD, and the Commission each have the
authority to impose trading halts for individual securities, for classes of
securities, and on markets as a whole. There are four types
of trading halts: (1) halts due to primary or regional market order
See, e.g., Amex Rule 117, NASD Rule 4120(a)(3),
NYSE Rules 80B and 717. Pursuant to Exchange Act
Sections 12(k)(1)(A) and (B), the Commission may
suspend trading in any security for up to 10 days,
and all trading on any national securities
exchange or otherwise, for up to 90 days. 15
U.S.C. 78l(k)(1)(A) and (B).
======END OF PAGE 137======
imbalance, or operational problems; (2) regulatory halts (as a result of
dissemination of material news); (3) halts due to data processing or
telecommunications problems (e.g., the inability to disseminate quotations
or trade reports); and (4) Commission ordered halts. The existing
registered exchanges and the NASD currently have different rules and
procedures in place for applying trading halts, and a new interpretation of
the term "exchange" would result in a broader application of these trading
halts in some instances. Because many alternative trading systems are
currently operated by registered broker-dealers, they are subject to NASD
rules, including rules requiring them to comply with trading halts imposed
by the NASD. If registered as national securities exchanges, however, such
systems would be required to impose their own trading halts.
In addition, a trading system that was regulated as an exchange, would need
to implement circuit breaker rules for extraordinary market volatility.
Question 81: What effect would the requirements to impose trading
halts or circuit breakers in some circumstances have upon alternative
trading systems if such systems were regulated as exchanges?
c. Oversight of Non-Broker-Dealers That Have Access to
Exchanges and Clearance and Settlement of Non-Broker-
Dealer Trades
As discussed above, Congress intended for an exchange that allowed
non-broker-dealers to access its facilities to be responsible for
For example, a newly registered exchange would be
required under Exchange Act Rule 11Ac1-1, 17 CFR
240.11Ac1-1 (the "Quote Rule"), to halt trading
when neither quotation nor transaction information
can be disseminated.
======END OF PAGE 138======
overseeing the trading of such non-broker-dealers. The
scheme of self-regulation and market oversight codified in the Exchange Act
relies primarily on trading markets to implement and operate market
mechanisms for enforcing the federal securities laws and for ensuring that
all market participants have adequate access to market information. This
system may be able to function effectively only if all significant trading
activity and market participants are supervised by an SRO. If entities can
participate directly in the market in a significant way without being
overseen by an SRO, market mechanisms designed to ensure transparency and
to surveil for fraud and manipulation may not be fully effective. The
Commission's findings in the NASD 21(a) Report, discussed above,
demonstrate the problems that arise when trading occurs on markets that are
not subject to effective market oversight. Therefore, it
would probably be necessary for any registered exchange to supervise the
trading of non-broker-dealer participants in the same manner as it
supervises broker-dealer trading. For example, as part of its obligations
under the Exchange Act, each exchange currently maintains procedures to
surveil for insider trading and manipulation on that exchange. These
As noted above, Congress adopted Section 6(f)
specifically to ensure that the Commission and
exchanges have sufficient authority both to limit
the ability of non-members to utilize exchange
facilities and to ensure that transactions on that
exchange are effected in accordance with
applicable exchange rules regardless of whether
the particular transaction is brought to the
exchange by a broker-dealer that is not an
exchange member or by an investor who is not
utilizing a broker. See supra Section
II.B.2.a.(i).
See NASD 21(a) Report, supra note 20.
======END OF PAGE 139======
procedures, while differing among exchanges, generally identify trading
anomalies based on historical and current data, review trading data to
isolate suspicious activity and, if suspicious activity is found, refer the
matter for enforcement proceedings. If an exchange permitted
institutions to directly participate in trading as members, the Commission,
pursuant to its authority under Section 6(f) of the Exchange Act, could
require that exchange to enforce its rules with respect to such non-broker-
dealers by conducting equivalent surveillance procedures.
Nevertheless, it may not be appropriate to enforce exchange rules for
non-broker-dealers in precisely the same manner as for broker-dealers. For
example, although an exchange would have to maintain surveillance
procedures for all of its participants, an exchange may require a non-
broker-dealer participant to provide different information in the course of
cooperating with investigations than would be required from broker-dealer
participants. Similarly, in addition to the Commission's net capital
requirements for broker-dealers, each registered exchange
currently requires their broker-dealer members to maintain minimum levels
of capital. Exchanges could consider applying different
financial requirements to non-broker-dealer participants than they
An exchange's surveillance depends on the nature
of trading that occurs, and the type of securities
that are traded on the exchange.
17 CFR 240.15c3-1. Capital requirements help to
ensure that broker-dealers maintain liquid assets
in sufficient amounts to enable them to satisfy
their obligations promptly and to provide a
cushion of liquid assets to protect against
potential market and credit risks.
See, e.g., NYSE Rule 325.
======END OF PAGE 140======
currently apply to broker-dealers.
In any case, institutions that trade for accounts other than their
own, maintain custody of customer funds or securities, act as specialists
or market makers, or otherwise act as brokers or dealers would be required
to register as broker-dealers under the Exchange Act. Entities that engage
in broker-dealer activities would continue to be required to comply with
broker-dealer registration requirements, Exchange Act and SRO capital and
books and records requirements, as well as prohibitions under Section 11(a)
and other provisions of the Exchange Act designed to protect against
conflicts of interest between an exchange member trading for its own
account on an exchange and its trading on an agency basis for other
accounts.
In addition, integration of alternative trading systems that have
institutional participants into exchange registration will raise issues
regarding clearance and settlement of the trades of those participants.
Currently, institutions do not participate directly in the clearance and
settlement process at registered clearing agencies such as the National
Securities Clearing Corporation ("NSCC") or The Depository Trust Company
("DTC"). There is, however, no statutory prohibition against
For example, broker-dealers are prohibited from
trading ahead of a customer's order, frontrunning,
free-riding and withholding, and maintaining
accounts for the employees of other broker-dealers
without notifying such broker-dealers.
Institutions will generally hire a bank or broker-
dealer that is a member of DTC to act as custodian
on their behalf. Institutions can be members of
DTC's Institutional Delivery system for purposes
of the confirmation/affirmation process, but the
actual settlement of securities transactions
(continued...)
======END OF PAGE 141======
the admission of institutions as members of registered clearing
agencies. Conversely, there are no provisions under the
Exchange Act, the rules thereunder, or current SRO rules, that require a
member conducting trades on an exchange to be a direct member of a clearing
agency. Currently, for example, broker-dealer members of an exchange may
use a clearing broker for processing trades conducted on an exchange.
Similarly, the Commission anticipates that institutions that conduct trades
on newly registered exchanges could continue to use separate entities for
clearance and settlement of trades.
In order to provide future institutional members the same clearance
and settlement choices available to current broker-dealer exchange members,
it may be appropriate for clearing agency membership to be open to
institutions. Such admission would be subject to corresponding clearing
agency rules assuring appropriate safeguards and qualifications.
Question 82: What impact would registration of an alternative trading
system as an exchange have on the institutional participants of that
trading system, including registered investment companies?
Question 83: If the Commission allows institutions to effect
transactions on exchanges without the services of a broker, to what
(...continued)
(i.e., the transfer of money and securities) at
DTC occurs between the institutions' broker-
dealers and custodians. Similarly, NSCC is
designed to process street-side settlement between
financial intermediaries such as broker-dealers.
Therefore, institutions are not members of NSCC
for the purposes of settlement of trades.
In fact, Section 17A of the Exchange Act requires
that registered investment companies and insurance
companies be permitted to become members of
clearing agencies. 15 U.S.C. 78q-1(b)(3)(B).
======END OF PAGE 142======
extent should an exchange's obligations to surveil its market and
enforce its rules and the federal securities laws apply to such
institutions?
Question 84: How could an exchange adequately supervise institutions
that effect transactions on an exchange without the services of a
broker?
Question 85: What, if any, accommodations should be made with respect
to an exchange's surveillance, enforcement, and other SRO obligations
with respect to institutions that transact business on that exchange?
Question 86: How could institutions that directly access exchanges be
integrated into existing systems for clearance and settlement?
d. Application of Broker-Dealer Regulation to Certain
Exchanges
Under the alternative discussed above, most alternative trading
systems would be regulated as exempted exchanges. A few alternative
trading systems, however, combine both the services of a market and those
of a broker-dealer. For example, some systems perform market functions by
operating electronic limit order books or crossing sessions. These same
systems employ persons to actively search for buyers and
sellers or use their discretion in executing
orders.
The system employee, for example, negotiates or
assists in negotiating the terms of a particular
trade on behalf of a participant by initiating
communications with potential counterparties.
These additional broker-dealer services may
include directing the order to another market or
broker-dealer for execution, or executing the
order as principal.
======END OF PAGE 143======
Just as broker-dealer regulation has not effectively integrated
alternative trading systems into market regulation, the current framework
for regulating exchanges is not well-suited to address concerns raised by
traditional broker or dealer activities. As a result, the Commission would
consider whether markets that are regulated as either exempted exchanges or
as registered national securities exchanges, but that also provide
traditional brokerage services, should be subject to broker-dealer
regulation as well. Application of broker-dealer regulation in such
circumstances may not be inappropriate or necessarily duplicative.
This approach is consistent with the way in which exchanges and the
persons that trade on those exchanges have traditionally been regulated.
For example, specialists are registered broker-dealers that carry on a
business for themselves while also serving the exchange as a whole. Among
other things, specialists help to ensure the maintenance of a continuous
and liquid market. They also often provide individualized services to
their customers, such as alerting customers to market movements and
forwarding orders to other markets. Although they perform many services
for exchanges, specialists are regulated as broker-dealers. There is no
reason, however, why an exchange could not choose to perform these
activities itself rather than rely on third parties to perform them.
In such a situation, the Commission would have to consider how best to
integrate the regulation of these broker-dealer activities with the
regulation of the exchange's market activities. To the extent that
exchange and broker-dealer regulations overlap, the Commission could
======END OF PAGE 144======
determine which requirements a dually registered entity would
follow.
The Commission does not anticipate that a revised interpretation of
the term "exchange" would include other entities that currently provide
services to participants in the U.S. securities markets without being
registered as broker-dealers or as exchanges. Examples of such service
providers are those that restrict their activities to providing
communication links between exchanges and broker-dealers and between
broker-dealers and customers. Entities that only provide such message
routing services likely would not be required under this approach to
register with the Commission as either broker-dealers or as national
securities exchanges. Entities that provide such
communication links and also have affiliates that use those links to
perform market functions, however, could be deemed to be facilities of an
exchange. In general, in determining whether broker-dealer or exchange
regulation would be appropriate for a particular entity, communication
links offered in conjunction with other services would have to be viewed in
their entirety.
For example, certain broker-dealer trading
systems, which are subject to Exchange Act Rule
17a-23, would be exchanges under the proposed new
interpretation of the term "exchange." To prevent
an alternative trading system from being subject
to the requirements of both Rule 17a-23 and an
exempted exchange or a national securities
exchange, the Commission could amend Rule 17a-23
as necessary to avoid duplicative regulation.
See, e.g., Letter from Richard R. Lindsey,
Director, Division of Market Regulation, SEC, to
Scott W. Campbell, V.P. & Assoc. General Counsel,
Charles Schwab & Co., Inc. (Nov. 27, 1996).
======END OF PAGE 145======
Question 87: Under what conditions should an entity be subject to
both exchange and broker-dealer regulation?
Question 88: Should a dually registered entity be required to
formally separate its exchange operations from its broker-dealer
operations (e.g., through use of separate subsidiaries)?
C. Conclusion
The exchange-based approach described above might address the gaps
created by the current approach to oversight of alternative trading
systems, as well as many of the concerns raised by the broker-dealer based
approach, and could result in more consistent market protections over time.
In addition, such an approach might contribute substantial regulatory
certainty and the application of fair and equitable principles of trade to
alternative trading systems. As noted above, however, such an approach
might also have significant effects on existing exchanges, alternative
trading systems, and market participants. To some extent, many alternative
trading systems that would be considered exempted exchanges under this
approach would be subject to less regulation than they currently are, while
the few significant alternative trading systems would be subject to more
substantial regulatory requirements. This approach would also potentially
require greater adjustment to existing NMS mechanisms to accommodate newly
registered exchanges than would a broker-dealer based approach.
Question 89: Would this approach be an effective means of addressing
the issues raised by the growth alternative trading systems? What
would be the benefits of such an approach? What would be the
drawbacks of such an approach?
V. The Commission Could Consider Ways in Which Requirements Might Be
======END OF PAGE 146======
Reduced or Expedited for Registered Exchanges
The effects of technology on domestic markets have not been limited to
alternative trading systems. Registered exchanges and Nasdaq are also
engaged in applying technology to respond to the fast changing competitive
pressures of modern securities markets. In addition to considering the
regulatory position of alternative trading systems, the Commission could
therefore consider whether there are other areas of its approach to
regulation of markets that would benefit from reevaluation. Specifically,
the Commission could examine ways to reduce unnecessary regulatory
requirements that make it difficult for these registered entities to remain
competitive in changing business environments. The Commission has tried to
fulfill its obligation under the Exchange Act to oversee the activities of
exchanges and securities associations in a manner that is flexible and
responsive to market developments and that allows for innovation by these
entities. This has entailed ongoing consideration of additional ways in
which the obligations imposed by the Exchange Act on registered exchanges
and securities associations may be streamlined, without sacrificing
investor protection or market integrity.
The Commission could consider what changes might be made to expedite
exchanges' and securities associations' procedures for changing their
rules, and how automation might be used to lower the costs and improve the
effectiveness of their surveillance and enforcement responsibilities. The
Commission could also consider what changes might be made to give exchanges
and securities associations greater flexibility in determining how to
fulfill their regulatory obligations. For example, while it is generally
in the public interest for each exchange to retain ultimate responsibility
======END OF PAGE 147======
for fulfilling its statutory obligations, it is clear that smaller SROs do
not benefit from the economies and efficiencies of scale available to SROs
that supervise larger memberships. In addition, larger SROs may obtain
greater cost efficiencies by offering their services to other SROs for a
fee. This type of "outsourcing" could be a useful tool for exchanges and
securities associations.
A. Ways to Further Expedite Rule Filings
Section 19(b)(1) of the Exchange Act requires SROs to file copies of
proposed rules and rule amendments with the Commission, accompanied by a
concise general statement of the basis and purpose of the proposed rule
change. Once a proposed rule change is filed, the Commission
is required to publish notice of it and provide an opportunity for public
comment. This process serves a critical role in giving the Commission
sufficient oversight authority to ensure that exchanges and securities
associations carry out their self-regulatory obligations vigilantly and
effectively.
Between 1934 and 1975, the Exchange Act did not give the Commission
adequate authority over SRO rulemaking to act promptly and effectively
The scope of this requirement depends upon what
constitutes a "rule" under the Exchange Act. If
something does not rise to the level of a "rule,"
Section 19(b)(1) does not apply. Sections
3(a)(27) and (29) of the Exchange Act define the
rules of an SRO broadly to include not only the
constitution, articles of incorporation, and
bylaws, but also any stated policies, practices,
and interpretations that the Commission, by rule,
determines to be rules of an SRO. See Exchange
Act Rule 19b-4, 17 CFR 240.19b-4.
======END OF PAGE 148======
where a rule or proposed rule might be injurious to the public
interest. During that time, the Commission carried out this
responsibility by relying on inspections and by conducting administrative
proceedings to effect needed changes in exchange rules. The
Commission had limited authority to prevent the adoption of a particular
exchange rule, or to amend rules once they had been adopted; Section 19(b)
of the Exchange Act only gave the Commission the authority to amend
exchange rules related to certain enumerated matters. As a
result, with respect to the majority of exchange rules, although exchanges
would consider concerns raised by the Commission or its staff, exchanges
were not obligated to address those concerns. Moreover,
See SEC, Study of Unsafe and Unsound Practices of
Brokers and Dealers, H.R. Rep. No. 231, 92d Cong.,
1st Sess. 6 (1971).
The Commission's effort to eliminate fixed
commission rates is illustrative of this process
and why it was problematic. See Securities
Exchange Act Release No. 11203 (Jan. 23, 1975), 40
FR 7394 (Feb. 20, 1975).
Before 1975, exchanges were allowed to adopt,
without Commission approval, any rule not
inconsistent with either the Exchange Act or a
Commission rule, and were required to furnish the
Commission with copies of rule amendments only
upon their adoption. The Commission, however,
could alter or supplement exchange rules that
related to certain enumerated matters pursuant to
defined procedures. In contrast, registered
securities associations were required to file rule
changes with the Commission 30 days before they
became effective, and the Commission had the
authority to prevent proposals from taking effect.
The Commission could also alter, supplement, or
abrogate an association's rule in certain
circumstances. See generally Special Study, supra
note 4, at 703-06.
See Special Study, supra note 4, at 711.
======END OF PAGE 149======
persons with a significant stake were not provided with notice or an
opportunity to comment on a proposed rule change or on the need or
justification for a proposal.
The 1975 Amendments established a new uniform procedure for both
exchanges and securities associations that required SRO rule changes to be
justified to, and reviewed by, the Commission after an opportunity for
public comment. In addition, Congress expanded the
Commission's authority to permit it to amend all SRO rules.
The legislative history of the 1975 Amendments indicates that Congress
intended to clarify and strengthen the Commission's oversight role with
respect to SROs and, specifically, to ensure that the Commission had the
tools it needed to provide meaningful oversight of SRO rules and the
See Securities Industry Study, Subcomm. on
Securities, Senate Committee on Banking, Housing &
Urban Affairs, S. Doc. No. 13, 93d Cong., 1st
Sess. 156-7, 198 (1973); Note, Informal Bargaining
Process: An Analysis of the SEC's Regulation of
the New York Stock Exchange, 80 Yale L.J. 832
(1971).
In order to provide interested persons with an
opportunity to obtain accurate information on rule
proposals and to participate in the review and
evaluation of SROs' proposed rule changes, the
1975 Amendments required SROs to file an
explanation or justification for their proposals
and the Commission to publish notice of the SROs'
proposed rule changes. Congress intended this
requirement to hold the SROs to the same standards
of policy justification that the Administrative
Procedures Act imposes on the Commission. See
Exchange Act 19(b)(1), 15 U.S.C. 78s(b)(1); S.
Rep. No. 75, supra note 22, at 29-32.
Exchange Act 19(c), 15 U.S.C. 78s(c).
======END OF PAGE 150======
rulemaking process. Congress intended that the Commission
would conduct a comprehensive review of proposed rule changes, including
the justification for the change, any burden on competition and the public
interest that the change may impose, and public comments received
concerning the rule change. The Commission staff fulfills
this responsibility by conducting a careful review of every rule filing it
receives. This review often requires the Commission staff to weigh complex
and serious issues raised by the proposed changes. The rule filing process
also gives the public an opportunity to express its views as to the
competitive and other effects of any significant rule changes. For all
these reasons, it may be appropriate for all exchanges, including newly
registered alternative trading systems, to comply with the rule filing
requirements of Section 19(b).
Nonetheless, the Commission understands that the time required for
solicitation and review of public comments can delay exchanges' and
securities associations' implementation of innovative proposals and
administrative or non-controversial filings. In response to this concern,
the Commission has already streamlined its internal process for reviewing
See, e.g., S. Rep. No. 75, supra note 22.
In the new regulatory environment created by this bill,
self-regulation would be continued, but the SEC would
be expected to play a much larger role than it has in
the past to ensure that there is no gap between self-
regulatory performance and regulatory need, and, when
appropriate, to provide leadership for the development
of a more coherent and rational regulatory structure to
correspond to and to police effectively the new
national market system.
Id. at 2.
Id.
======END OF PAGE 151======
and approving SRO rule filings. This has reduced the average number of
days between the filing of a proposed rule change by an SRO and the
approval, withdrawal, or disapproval of the rule filing from 349 days at
the beginning of fiscal year 1994 to 74 days at the end of fiscal year
1996.
In addition, to respond to SRO requests that the rule review process
be expedited, in December 1994, the Commission adopted amendments to Rule
19b-4, which expanded the scope of proposed rule changes that may become
effective immediately upon filing pursuant to Section 19(b)(3)(A) of the
Exchange Act. These amendments permitted SRO rule changes
concerning routine procedural and administrative modifications to existing
order-entry and trading systems to become effective immediately upon
filing. Certain non-controversial filings were also permitted to become
operational 30 days after filing with the Commission, provided the SRO gave
written notice to the Commission five business days prior to the
filing. These amendments to Rule 19b-4, in part, were
Section 19(b)(3)(A) of the Exchange Act sets forth
certain specified categories of rule changes that
may become effective upon filing. These include
rule changes that: (1) constitute a stated policy,
practice, or interpretation with respect to the
meaning, administration, or enforcement of an
existing rule of the SRO; (2) establish or change
a due, fee, or other charge imposed by the SRO; or
(3) are concerned solely with the administration
of the SRO. In addition, consistent with the
public interest and the purposes of this
subsection, the Commission may specify other
categories of rule filings that may become
effective upon filing. 15 U.S.C. 78s(b)(3)(A).
See Securities Exchange Act Release No. 35123
(Dec. 20, 1994), 59 FR 66692 (Dec. 28, 1994).
Particularly in the area relating to new exchange-
(continued...)
======END OF PAGE 152======
intended to enhance SROs' ability to implement prompt, flexible, and
innovative systems changes. The Commission staff has also
(...continued)
traded products, the Commission continues to
reduce the number of days between filing and
allowed trading of those products that do not
raise significant regulatory issues or concerns.
For example, when an exchange seeks to trade a
product that meets generic criteria for listing
options on narrow-based indexes, the time period
between filing and allowed trading of the product
can be shortened considerably. See, e.g.,
Securities Exchange Act Release No. 38307 (Feb.
19, 1997), 62 FR 8469 (Feb. 24, 1997) (options on
The de Jager Year 2000 Index); Securities Exchange
Act Release No. 38207 (Jan. 27, 1997), 62 FR 5268
(Feb. 4, 1997) (options and LEAPS on the Phlx Oil
Service Index); Securities Exchange Act Release
No. 37312 (June 14, 1996), 61 FR 31570 (June 20,
1996) (options on The Morgan Stanley Commodity
Related Equity Index); Securities Exchange Act
Release No. 37115 (Apr. 15, 1996), 61 FR 17741
(Apr. 22, 1996) (options on the CBOE Gold Index);
Securities Exchange Act Release No. 37026 (Mar.
26, 1996), 61 FR 4502 (Apr. 3, 1996) (options on
the Chicago Board Options Exchange Computer
Networking Index). The exchange may trade the new
product 30 days after the date the rule change is
filed with the Commission.
It appears that SROs, including exchanges, could
take better advantage of the expedited process
available under Section 19(b)(3)(A) of the
Exchange Act. In fiscal year 1996, for example,
out of a total of 552 rule changes filed with the
Commission, only 18 (or 3.5%) were filed under the
expanded expedited process. Similarly, in fiscal
year 1995, only 12 out of a total of 593 rule
changes (2%) were filed under the expanded
expedited process. SROs could also facilitate the
prompt publication of notices of proposed rule
changes by submitting rule filings in such a form
that enables the staff to expedite their review.
The Commission strongly encourages SROs to
evaluate their internal procedures for drafting,
reviewing, and submitting rule filings to take
greater advantage of expedited procedures and to
ensure complete filings that will enable the
Commission to respond promptly.
======END OF PAGE 153======
taken a flexible approach in applying the expedited procedures under Rule
19b-4. For example, filings that are virtually identical to an SRO filing
already approved by the Commission can often be approved on an accelerated
basis, particularly in the context of new product listing standards that
duplicate listing standards already approved for an identical product on
another exchange.
Nonetheless, there may be additional ways in which the Commission
could reduce rule filing requirements to facilitate a rapid response by
SROs to changing market conditions and competitive pressures. For example,
the Commission could consider further expanding the scope of proposed rule
changes eligible for effectiveness immediately upon filing to include, for
example, any proposed changes to listing standards to accommodate new
products. In expanding the scope of rules eligible for this treatment, it
may be appropriate to require an SRO to make an affirmative statement that
it has undertaken a review of the Commission's eligibility criteria for
See Securities Exchange Act Release No. 36296
(Sept. 28, 1995), 60 FR 52234 (Oct. 5, 1995)
(relating to listing and trading of broad-based
index warrants on Nasdaq); Securities Exchange Act
Release No. 36165 (Aug. 29, 1995), 60 FR 46653
(Sept. 7, 1995) (establishing the NYSE's uniform
listing and trading guidelines for stock index,
currency, and currency index warrants); Securities
Exchange Act Release No. 36166 (Aug. 29, 1995), 60
FR 46660 (Sept. 7, 1995) (establishing PCX's
uniform listing and trading guidelines for stock
index, currency, and currency index warrants);
Securities Exchange Act Release No. 36167 (Aug.
29, 1995), 60 FR 46667 (Sept. 7, 1995)
(establishing Phlx's uniform listing and trading
guidelines for stock index, currency, and currency
index warrants); Securities Exchange Act Release
No. 36169 (Aug. 29, 1995), 60 FR 46644 (Sept. 7,
1995) (establishing CBOE's uniform listing and
trading guidelines for stock index, currency, and
currency index warrants).
======END OF PAGE 154======
immediate effectiveness under Rule 19b-4 and is satisfied that the rule
filing being submitted conforms to such requirements.
The Commission could also consider exempting certain SRO programs
designed to implement innovative new trading systems or mechanisms from
rule filing requirements during development and initial operating stages.
In the past several years, a few SROs have attempted to implement
innovative trading structures for their members. For example, in 1991, the
NYSE established after-hours crossing systems that automate the execution
of single stock orders and baskets of securities, and in
1994, the CHX developed the Chicago Match system. Although
neither program has generated significant trading activity,
in both cases, the exchanges submitted rule filings prior to operation.
Because of the innovative nature of such systems for the sponsoring
exchanges, the approval process was protracted. Alternative trading
systems that offer similarly innovative, start-up services today are not
required to follow the same procedures prior to operation of the services.
See Securities Exchange Act Release No. 29237 (May
24, 1991), 56 FR 24853 (May 31, 1991); Securities
Exchange Act Release No. 32368 (May 25, 1993), 58
FR 31565 (June 3, 1993).
See, e.g., Securities Exchange Act Release No.
35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 1994)
(order approving Chicago Match, an electronic
matching system operated by the CHX, which
provided for the crossing of orders entered by CHX
members and non-members, including institutional
customers).
The NYSE's crossing sessions continue to generate
volume that is well below that of POSIT and the
smallest registered exchange. The CHX determined
not to continue operating Chicago Match in 1996.
See Sarah Gates, Will Anyone Miss Chicago Match,
Wall Street & Technology, Apr. 1996, at 26.
======END OF PAGE 155======
In addition, SROs have indicated that revealing the business plans for such
innovative programs prior to operation makes it more difficult for them to
compete effectively with alternative trading systems in offering start-up
services to their members.
The Commission believes that markets should be encouraged to innovate.
One way of facilitating innovation by exchanges and securities
associations, as well as vigorous competition among these markets, would be
to enable exchanges and securities associations to establish innovative
trading programs, apart from their other operations. For example, an
exchange may wish to establish an electronic book for the trading of
securities not traded on the exchange's primary system. Such programs
could then be subject to similar oversight as that applied to small, start-
up alternative trading systems, to the extent appropriate in light of
investor protection. Under such an approach, the Commission could exempt
pilot programs from rule filing requirements until such time as the program
obtained significant volume, was integrated with an exchange's or
securities association's other trading mechanisms, or otherwise began to
have significant market impact.
Any such proposal would require careful consideration as to the types
of programs that might be eligible for exemption, and other conditions that
might be appropriate in light of investor protection concerns, national
market system goals, and just and equitable principles of trade. As noted
above, one reason that Congress required SROs to submit rule filings was to
ensure that the interests of investors were considered in SRO actions, and
that persons with a significant stake were provided with notice and an
opportunity to comment on a proposed rule change. For example, pilot
======END OF PAGE 156======
programs that might be eligible for exemption could potentially function as
alternatives to trading through a market's primary system. In such
circumstances, these programs would affect not only investors whose orders
are executed on such systems, but also investors and traders who were not
given the opportunity to use the pilot program. Moreover, customers who
placed orders in the exchange's main trading system could also be affected,
e.g., if their orders did not have an opportunity to interact with orders
executed through the pilot program. For these reasons, it may not be
appropriate to make a rule filing exemption available for pilot programs
that trade the same securities, operate during the same time of day, or
have similar trading structures as a market's main trading system or are
otherwise linked to a market's primary operations.
In addition, the Commission could consider the appropriate standards
for determining whether a particular proposal would qualify as a pilot
program. Other issues to be considered would include whether any exemption
for pilot programs should be limited in duration, even if the programs did
not reach significant volume, and what would be the appropriate measure for
determining when a program would have limited volume in light of all
relevant factors. Finally, the Commission could consider how
SROs would notify the Commission and the SROs' participants prior to
implementing a pilot program, and disclose to participants in the pilot
program whether the quality or type of execution capabilities of the pilot
system differ from those of the exchange's established systems.
As discussed above, whether a trading system has
enough volume to have significant market impact
will differ depending upon, among other things,
the size and liquidity of the market for the
instruments traded.
======END OF PAGE 157======
Question 90: Would it be feasible for the Commission to expand the
scope of rules eligible for expedited treatment pursuant to Section
19(b)(3)(A) without jeopardizing the investor protection and market
integrity benefits of Commission oversight of exchange and other SRO
rule changes? If so, to what types of rule filings should immediate
effectiveness, pursuant to Section 19(b)(3)(A), be extended?
Question 91: If the Commission expands the scope of rule filings
eligible for treatment under Section 19(b)(3)(A) to include, for
example, certain types of new products, what conditions or
representations should be required of an SRO to ensure that the
proposed rule change is eligible for expedited treatment under Rule
19b-4?
Question 92: Should the Commission exempt markets' proposals to
implement new trading systems, separate from their primary trading
operations, from rule filing requirements? If so, should SROs be
permitted to operate pilot programs under such an exemption if they
trade the same securities, operate during the same hours, or utilize
similar trading procedures as the SRO's main trading system? Should
there be a limit on the number of pilot programs an SRO can operate
under an exemption at any one time? What other conditions should
apply to such exemption?
B. Surveillance and Enforcement
Technological advances have greatly increased an exchange's ability to
fulfill its enforcement obligations under the Exchange Act efficiently and
cost effectively. Some sponsors of trading systems have suggested that
automated trading activity requires less extensive surveillance, and that
======END OF PAGE 158======
markets with fully automated trading should not be required to conduct the
same surveillance as non-automated exchanges. This suggestion may be based
in part on the view that automation of trading algorithms may make it more
difficult for participants to trade in violation of the trading rules
embedded in those algorithms. While automation and embedded algorithms
alone cannot prevent insider trading or market manipulation,
automation may make it easier to detect potential and attempted abuses by
providing a full audit trail of trading activity. By circumscribing
participant trading activity, automation can also reduce the resources that
must be devoted to monitoring trading activities, which, consequently,
would reduce the costs of exchange regulation. For example, failures by
market makers to fulfill their obligation to honor quotations are easier to
detect in a fully automated environment. Accordingly, the
Commission is considering whether fully automated markets may be able to
fulfill their regulatory obligations in non-traditional ways.
Existing Commission initiatives and SRO plans that coordinate
supervision of broker-dealers that are members of more than one SRO
("common members") could also apply to newly registered exchanges. For
example, while exchanges are required to enforce compliance by their
While automation may reduce the cost and increase
the effectiveness of a market's surveillance
program, a responsible party must still be able to
recognize potentially manipulative activity and,
in many cases, review trading records.
See NASD 21(a) Report, supra note 20, at 28 and 45
for discussion of failures by market makers on the
Nasdaq market to honor their quotations or to
"back away," and steps that the NASD undertook, as
part of its settlement with the Commission, to
upgrade its capabilities to detect and prevent
such backing away.
======END OF PAGE 159======
members (and persons associated with their members) with applicable laws
and rules, the Commission has used its authority under Sections 17 and 19
of the Exchange Act to allocate oversight of common members to particular
exchanges, and to exempt exchanges from enforcement obligations with
respect to persons that are associated with a member, but that are not
engaged in the securities business. In order to avoid
unnecessary regulatory duplication, the Commission appoints a single SRO as
the designated examining authority ("DEA") to examine common members for
compliance with the financial responsibility requirements.
When an SRO has been named as a common member's DEA, all other SROs to
which the common member belongs are relieved of the responsibility to
examine the firm for compliance with applicable financial responsibility
rules. Consistent with past Commission action, the
Commission could continue to designate one SRO, such as the NASD or the
NYSE, as the primary DEA for common members of exchanges. The Commission
has also permitted existing SROs to contract with each other to allocate
See 17 CFR 240.17d-2; 17 CFR 240.19g2-1.
With respect to a common member, Section 17(d)(1)
of the Exchange Act authorizes the Commission, by
rule or order, to relieve an SRO of the
responsibility to receive regulatory reports, to
examine for and enforce compliance with applicable
statutes, rules and regulations, or to perform
other specified regulatory functions. 15 U.S.C.
78q(d)(1).
See Securities Exchange Act Release No. 23192 (May
1, 1986) 51 FR 17426 (May 12, 1986). Moreover,
Section 108 of the 1996 Amendments, supra note 68,
adds a provision to Section 17 of the Exchange Act
that calls for improving coordination of
supervision of members and elimination of any
unnecessary and burdensome duplication in the
examination process.
======END OF PAGE 160======
non-financial regulatory responsibilities. For example, the
Commission has approved a regulatory plan filed by the Amex, CBOE, NASD,
NYSE, PCX, and the Phlx that designates, with respect to each common
member, an SRO participating in the plan as a broker-dealer's options
Rule 17d-2 under the Exchange Act permits SROs to
establish joint plans for allocating the
regulatory responsibilities imposed by the
Exchange Act with respect to common members.
Securities Exchange Act Release No. 12935 (Oct.
28, 1976), 41 FR 49093 (Nov. 8, 1976). In
addition to the regulatory responsibilities it
otherwise has under the Exchange Act, the SRO to
which a firm is designated under these plans
assumes regulatory responsibilities allocated to
it. Under Rule 17d-2(c), the Commission may
declare any joint plan effective if, after
providing notice and opportunity for comment, it
determines that the plan is necessary or
appropriate in the public interest and for the
protection of investors, to foster cooperation and
coordination among the SROs, to remove impediments
to and foster the development of a national market
system and a national clearance and settlement
system, and in conformity with the factors set
forth in Section 17(d) of the Exchange Act. The
Commission has approved plans filed by the equity
exchanges and the NASD for the allocation of
regulatory responsibilities pursuant to Rule
17d-2. See, e.g., Securities Exchange Act Release
No. 13326 (Mar. 3, 1977), 42 FR 13878 (Mar. 14,
1977) (NYSE/Amex); Securities Exchange Act Release
No. 13536 (May 12, 1977), 42 FR 26264 (May 23,
1977) (NYSE/BSE); Securities Exchange Act Release
No. 14152 (Nov. 9, 1977), 42 FR 59339 (Nov. 16,
1977) (NYSE/CSE); Securities Exchange Act Release
No. 13535 (May 12, 1977), 42 FR 26269 (May 23,
1977) (NYSE/CHX); Securities Exchange Act Release
No. 13531 (May 12, 1977), 42 FR 26273 (May 23,
1977) (NYSE/PSE); Securities Exchange Act Release
No. 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1,
1977) (NYSE/Phlx); Securities Exchange Act Release
No. 15191 (Sep. 26, 1978), 43 FR 46093 (Oct. 5,
1978) (NASD/BSE, CSE, CHX and PSE); and Securities
Exchange Act Release No. 16858 (May 30, 1980), 45
FR 37927 (June 5, 1980) (NASD/BSE, CSE, CHX and
PSE).
======END OF PAGE 161======
examination authority. This designated SRO has sole regulatory
responsibility for certain options-related trading matters.
An SRO participating in a regulatory plan is relieved of regulatory
responsibilities with respect to a broker-dealer member of such an SRO, if
those regulatory responsibilities have been designated to another SRO under
the regulatory plan. These programs could also be applicable to newly
registered exchanges.
These plans permit an SRO to allocate its oversight obligations with
respect to certain members' compliance with various requirements. They do
not permit an SRO to allocate its oversight obligations with respect to the
activities taking place on its market. Currently, enforcement and
disciplinary actions for violations relating to transactions executed in an
SRO's market or rules unique to that SRO must be retained by that SRO.
Existing exchanges generally employ personnel and establish extensive
programs to fulfill this responsibility. Fully automated exchanges,
however, might be able to contract with other exchanges to perform these
activities while retaining ultimate responsibility for ensuring that these
activities are performed. Fully automated exchanges can produce
See Securities Exchange Act Release No. 20158
(Sept. 8, 1983), 48 FR 41265 (Sept. 14, 1983).
The SRO designated under the plan as a broker-
dealer's options examination authority is
responsible for conducting options-related sales
practice examinations and investigating
options-related customer complaints and
terminations for cause of associated persons. The
designated SRO is also responsible for examining a
firm's compliance with the provisions of
applicable federal securities laws and the rules
and regulations thereunder, its own rules, and the
rules of any SRO of which the firm is a member.
Id.
======END OF PAGE 162======
comprehensive, instantaneous automated records that can be monitored
remotely. As a result, it may be possible for such an exchange to contract
with another exchange to perform its day-to-day enforcement and
disciplinary activities. The Commission could consider whether allowing an
automated market to do so would be consistent with the public interest.
Another approach would be for fully automated exchanges to form a
separate SRO solely for the purpose of overseeing the activities of their
markets. This SRO, rather than the automated exchanges, would have the
responsibility for bringing enforcement and disciplinary actions for
violations relating to transactions executed on those exchanges. The
Commission seeks comment on the advisability and feasibility of such an
approach.
Question 93: Do differences between automated and non-automated
trading require materially different types or degrees of surveillance
or enforcement procedures?
Question 94: Which Exchange Act requirements applicable to registered
exchanges, if any, could be minimized or eliminated without
jeopardizing investor protection and market integrity?
Question 95: If an automated exchange contracts with another SRO to
perform its day-to-day enforcement and disciplinary activities, should
this affect the exchange's requirement to ensure fair representation
of its participants and the public in its governance?
Question 96: If an exchange contracts with another entity to perform
its oversight obligations, should that exchange continue to have
responsibility under the Exchange Act for ensuring that those
obligations are adequately fulfilled?
======END OF PAGE 163======
VI. Costs and Benefits of Revising the Regulation of Domestic Markets
The two alternatives discussed in Section IV could provide significant
benefits to U.S. securities markets and market participants. By
integrating all significant markets in the market regulatory framework,
these proposals would bolster the effectiveness of the national market
system by better protecting market participants. For example, if the
Commission were to continue to regulate alternative trading systems as
broker-dealers, but adopted additional regulations (the first approach
discussed in Section IV), the market as a whole would benefit from the
additional transparency provided by the public reporting of all orders
submitted to alternative trading systems. Moreover, enhancing the
surveillance of trading on alternative trading systems would benefit the
public by preventing fraud and manipulation. Similarly, by regulating
alternative trading systems under a tiered approach to exchange regulation,
investors and other market participants could benefit because, as
exchanges, significant alternative trading systems would be prohibited from
unfairly denying access, taking discriminatory action against participants,
imposing unreasonably discriminatory fees, or establishing anticompetitive
rules. In addition, because significant alternative trading systems would
be required to directly participate in market-wide plans such as the CQS,
CTA, OPRA, and ITS, investors could benefit from reductions in
misallocations of capital, inefficiency, and trading fragmentation.
Moreover, under the proposed reinterpretation of "exchange," investors and
the integrity of the market generally could benefit from alternative
trading systems sharing SRO responsibilities with currently registered
exchanges. In particular, the Commission's ability to prevent fraud and
======END OF PAGE 164======
manipulation would be strengthened.
The Commission also recognizes that the proposals discussed in this
release would have a substantial impact on the allocation of regulatory
costs among market participants. In particular, the additional obligations
contemplated under both alternative proposals to revise domestic market
regulation could impose costs on alternative trading systems. For example,
alternative trading systems could be required to adopt rules to prevent
fraud and manipulation, promote just and equitable principles of trade, and
not impose any unnecessary or inappropriate burden on competition.
Alternative trading systems could also be required to establish mechanisms
to assure regulatory oversight of their participants and review their
listing procedures. In addition, there would also be costs associated with
joining market-wide plans, such as the CQS, CTA, ITS, OPRA, and OTC-UTP.
These costs, however, would at least partially be offset because most
alternative trading systems would no longer be regulated as broker-dealers.
In addition, because alternative trading systems, as exchanges, would share
the responsibilities of self-regulation, the regulatory burden carried by
currently registered exchanges should be reduced. In contrast, integrating
these alternative trading systems into the mechanisms of the national
market system through broker-dealer regulation could entail additional
costs for the trading systems as well as their supervising SROs.
Question 97: What costs to investors and other market participants
are associated with the current regulation of alternative trading
systems as broker-dealers? Specifically, what costs are associated
with the potential denial of access by an alternative trading system?
======END OF PAGE 165======
Question 98: What costs are associated with each of the alternatives
for revising market regulation discussed above? For example, would
either of the two principal alternatives discussed in Section IV above
impose costs by limiting innovation? Would these costs be greater
than those imposed by the current regulatory approach?
Question 99: What regulatory costs can be shared by markets operating
simultaneously as self-regulatory organizations, and what regulatory
costs must be borne by each market individually? What are the
relative magnitudes of these costs (as a proportion of total costs)?
Question 100: Are there innovations or adjustments that can be made
to market wide plans such as CQS, CTA and ITS that will lead to lower
regulatory costs for exchanges under any of the alternatives for
regulating domestic markets?
Question 101: Total regulatory costs vary with a variety of factors
(e.g., volume of trade, degree of technology applied in trade). Of
these factors, which are most relevant in considering the alternatives
discussed above? For example, recognizing that some market mechanisms
may rely on some factors more than others, to what extent are
regulatory costs greater for particular mechanisms than others?
Question 102: What costs are associated with the responsibilities of
an SRO? Will the costs to existing SROs be reduced by registering
significant alternative trading systems as exchanges?
Question 103: What regulatory burdens currently inhibit innovation of
trading systems? How will the alternatives discussed above change the
incentives for innovation?
Question 104: Will the alternatives discussed above impose costs on
======END OF PAGE 166======
systems that differ depending on the nature of the trade? For
example, will the proposed regulatory revisions change the costs of
trades directly between customers relative to the costs of trades
between a customer and a dealer?
VII. Regulation of Foreign Market Activities in the United States
A. The Need for A Clear Regulatory Structure to Address U.S.
Investors' Electronic Cross-Border Trading
In addition to significantly changing the way domestic markets
operate, technology has given U.S. investors new and varied options for
accessing foreign markets. The desire of many investors to diversify their
portfolios through foreign investment has already resulted in an
exponential increase in trading in foreign securities by U.S.
persons. The use of advanced technology by broker-dealers,
markets, and other entities has the potential to greatly increase
institutions' and other U.S. investors' cross-border trading opportunities,
to make cross-border trading both more efficient and more affordable, and
to promote competition among global markets and intermediaries.
Until recently, in order to obtain current information regarding
foreign market activity and to purchase or sell securities on a foreign
market, a U.S. investor typically contacted a U.S. broker-dealer by
telephone or facsimile. The U.S. broker-dealer would then give the
investor current information and transmit the investor's order to a foreign
Between 1980 and 1995, the total activity by U.S.
persons in foreign securities grew from $53.1
billion to $2,573.6 billion, representing over a
4700% increase. Securities Industry Association,
1996 Securities Industry Fact Book 67 (forthcoming
June 1997).
======END OF PAGE 167======
broker-dealer member of the foreign market on which the
security was traded. Alternatively, the U.S. investor could contact a
foreign broker-dealer member of the foreign market directly. Today,
however, it is possible for U.S. investors to obtain real-time information
about trading on foreign markets from a number of different sources and to
enter and execute their orders on those markets electronically from the
United States.
For example, an investor that is not a member of a foreign market can
nonetheless trade directly on that market using electronic interfaces, by
linking to the market through a member of that market (typically the
investor's broker-dealer). The market member provides a direct, automated
link between the customer and the foreign market by connecting the
customer's computer system directly to its own, which is also connected
with the foreign market. This may be accomplished in a variety of ways,
including through the use of proprietary software, leased lines or a public
network such as the Internet. The member's systems will then automatically
distribute market information to the U.S. investor and route the investor's
orders directly to the market. Through these types of "pass-through"
linkages, the non-member customer can enjoy electronic trading capabilities
that are equivalent to the trading privileges of a member of the foreign
market. From the broker-dealer's and customer's perspectives, this type of
As used in this release, a "member" of a foreign
market includes any person to which a foreign
market provides access for the purpose of
effecting transactions on that market. This would
include any person that is a full or limited
member of a foreign market or that the foreign
market allows to electronically access its trading
facilities.
======END OF PAGE 168======
"pass-through" service enables the investor to send orders through the
electronic interface without the broker-dealer having prior knowledge of
each order or manually interpositioning itself in the trading process. As
a result, orders routed electronically by a customer to the exchange remain
under the customer's control until the moment of execution. This is in
contrast to traditional brokerage activities involving orders that are
routed from a customer to a foreign market member (or its affiliate), and
from the member to the exchange. From the perspective of the foreign
market, orders sent by a broker-dealer customer through a member's
electronic interface may be indistinguishable from orders placed directly
by the member. Some broker-dealers have also begun to
facilitate trading directly on the facilities of foreign markets in which
those broker-dealers are not members, for their U.S. customers or
affiliates. This is typically accomplished through agreement or
affiliation with a local member of that market.
In addition to allowing investors that are not members to trade
directly on foreign markets, technological advances have enabled market
members themselves to trade from remote locations outside of particular
markets' home countries. Many foreign markets have integrated new
technology into their trading processes in recent years, either by using
computers in combination with traditional floor trading
procedures, or by completely automating their trading
Although orders originate from a non-member, they
are electronically identified, or "stamped," as
coming from the member providing the interface.
For example, in September 1994, the Amsterdam
Stock Exchange introduced a new electronic trading
(continued...)
======END OF PAGE 169======
facilities. This enhanced technology enables members of
(...continued)
system that permits banks and broker-dealers to
effect wholesale trades on-screen using the
Automatic Interprofessional Dealing System
Amsterdam ("AIDA"). This system permits exchange
participants to enter bids and offers and to
execute trades via a remote computer located in
their offices. The Netherlands, Institutional
Investor, Inc., Sept. 16, 1996, at 11; The
Amsterdam Stock Exchange - An Overview - Amsterdam
Stock Exchange, Business Monitor, Mar. 30, 1995.
Similarly, Frankfurt's Deutsche Borse provides
remote access in London, Amsterdam, Paris, and
Zurich, and has attracted 44 remote members. The
number of remote members of the Deutsche Borse is
predicted to swell to at least 100 within three to
five years. Laura Covill, Survival of the
Fittest, ABI/INFORM, Aug. 1996, at 60. In
addition, the Athens Stock Exchange has installed
an electronic trading system that allows members
to execute orders via exchange-owned terminals.
Internet Site of the Athens Stock Exchange,
address: http://www.ase.gr/waser.htm (Dec. 5,
1996).
For example, since 1989, OM Stockholm (formerly
the Stockholm Stock Exchange) has been completely
electronic, and has remote members in London,
Denmark, Norway, Finland, and Switzerland. OMLX,
the London Securities & Derivatives Exchange,
which is owned by the same company as OM
Stockholm, is also a completely electronic trading
system. See Laura Covill, Survival of the
Fittest, ABI/INFORM, Aug. 1996, at 60; Hugh
Carnegy, Survey - Swedish Banking; Two Dynamic
Exchanges, Fin. Times, June 20, 1996, at 6.
Tradepoint, a London-based electronic stock
exchange, started trading in September 1995. See
Henry Harrington, Survey of European Stock
Exchanges, Fin. Times, Feb. 16, 1996. The Paris
Bourse is now an entirely computerized stock
market. Supercac, a system linked to member firms
and other intermediaries collecting client orders,
went on line in April 1995 and allows for
continuous, automated trade execution to take
place on the Paris Bourse. See Internet Site of
The Paris Stock Exchange, address:
http://www.bourse-de-paris.fr (Nov. 6, 1996);
(continued...)
======END OF PAGE 170======
those markets to trade without being physically present on a market "floor"
or establishing a physical presence in a market's home country. As a
result, several foreign markets have begun to offer their members in non-
U.S. jurisdictions "remote" access to their trading facilities, typically
by installing proprietary market terminals in the members' offices, by
providing data feeds or codes for use with software operated through the
members' own computers, or by allowing members to access a market's trading
facilities through third party service vendors or public networks (such as
the Internet). In recent years, several foreign markets have proposed
permitting U.S. broker-dealers and institutional investors to become market
(...continued)
Henry Harrington, Survey of European Stock
Exchanges, Fin. Times, Feb. 16, 1996. The
purchase by the Toronto Stock Exchange ("TSE") of
the Paris Bourse's Supercac software enabled the
TSE to close its floor on April 24, 1997. See
Toronto Stock Exchange Closes its Trading Floor,
The Wall Street J., Apr. 24, 1997, at C15. Other
examples of completely automated exchanges include
the MEFF Renta Fija and MEFF Renta Variable in
Spain, the New Zealand Stock Exchange, the Korean
Stock Exchange, the Philippine Stock Exchange, the
Singapore Stock Exchange, and the Thailand Stock
Exchange. Foreign futures and options markets
have also embraced electronic trading systems.
For example, the Tokyo International Financial
Futures Exchange, the Osaka Futures and Options
Exchange, the Swiss Options and Financial Futures
Exchange, the Irish Futures and Options Exchange,
and the New Zealand Futures and Options Exchanges
are completely electronic. See Hughes Levecq &
Bruce W. Weber, Electronic Markets and Floor
Markets: Competition for Trading Volumes in
Futures and Options Exchanges, Center for Research
on Information Systems, Working Paper Series No.
IS-95-20, June 15, 1995; Allan D. Grody & Hughes
Levecq, Past, Present and Future: The Evolution
and Development of Electronic Financial Markets,
Center for Research on Information Systems,
Working Paper Series No. IS-95-21, Nov. 1993.
======END OF PAGE 171======
members through similar remote access arrangements. If this
remote access were offered in the United States, U.S. investors would have
the ability to trade directly on foreign markets and to bypass broker-
dealers.
These are examples of ways in which U.S. investors might access
foreign markets. As technology evolves and investor comfort with
electronic trading increases, other types of access will likely develop as
well, including those that may make greater use of the Internet.
1. The Applicability of the U.S. Regulatory Structure to the
Activities of Access Providers Has Not Been Expressly
Addressed
When a foreign market, broker-dealer, or other entity provides the
type of direct foreign market access described above to investors located
in the United States (hereinafter referred to as an "access provider"), its
activities typically differ from both traditional brokerage activities and
For example, Deutsche Terminborse ("DTB"),
Germany's electronic futures and options market,
installed computer terminals in the United States
for trading non-U.S. futures products. See Letter
from Andrea M. Corcoran, Director, Division of
Trading and Markets, Commodity Futures Trading
Commission, to Lawrence H. Hunt, Jr., Esq., Sidley
& Austin (Feb. 29, 1996) (no-action letter
authorizing DTB to install and use computer
terminals in the United States in connection with
the purchase and sale of certain futures and
options contracts). The no-action letter
explicitly did not address securities law issues.
See also Mark J. Arend, Securities Trading: How
Electronic Markets Empower Institutional
Investors, Global Investment, Dec. 1996, at 30;
The Netherlands, Institutional Investor, Inc.,
Sept. 16, 1996, at 11; Laura Covill, Survival of
the Fittest, ABI/INFORM, Aug. 1996, at 60;
Business, Legal News from Around Europe, Buraff
Publications, May 13, 1996.
======END OF PAGE 172======
the activities of exchanges. The Commission to date has not expressly
addressed the regulatory status of entities that provide U.S. persons with
the ability to trade directly on foreign markets from the United States.
While some access providers may be registered as U.S. broker-dealers
because of their other activities, the lack of regulatory guidance in this
context has discouraged other parties from offering U.S. persons foreign
market access. Similarly, foreign markets have been reluctant to permit
U.S. persons to become members of their markets without assurances from the
Commission that they would not be required to register as national
securities exchanges. The Commission therefore is soliciting
comment on how best to address U.S. investors' increasing access to foreign
markets. Specifically, the Commission requests comment on whether
investors could benefit from a clearer regulatory framework for entities
that provide U.S. investors with the technological capability to trade
directly on foreign markets from the United States.
2. U.S. Investors' Ability to Trade Directly on a Foreign
Market And Investor Protection Concerns Under the Federal
Securities Laws
In addressing issues raised by cross-border trading, it is important
to ensure that investors are provided with certain key protections under
the federal securities laws. From an investor's perspective, trading on a
foreign market through an access provider is often indistinguishable from
Several foreign markets have proposed to provide
U.S. investors with direct electronic access to
their trading systems. In conjunction with these
proposals, the foreign markets have requested
certain relief from U.S. exchange and broker-
dealer registration requirements.
======END OF PAGE 173======
trading on a domestic market. These similarities could lead many investors
to expect that such trading would be subject to the same protections
provided by the U.S. securities laws. There are, however, significant
differences in the protections available to investors trading on domestic
U.S. markets, and those available to investors trading on foreign markets
from the United States. For example, the U.S. securities laws provide
significant protections to investors trading on U.S. markets. These
protections include assurances that markets and intermediaries will
disclose information regarding the rules governing trading operations, as
well as requirements regarding transaction reporting and issuer disclosure
practices. In addition, U.S. securities laws provide the Commission with
the tools to detect and deter fraud and manipulation. Because foreign
securities laws are generally not designed to provide these protections to
U.S. investors that directly trade on their markets, in the absence of
disclosure these differences have the potential to mislead U.S. investors
that have come to rely on the U.S. securities laws.
The Commission has been examining alternative regulatory frameworks
for addressing these concerns. As an initial matter, the optimal framework
for addressing these issues should not impose unnecessary obligations on
foreign markets that could effectively preclude U.S. investors from taking
advantage of an otherwise efficient, cost-effective investment alternative.
Cross-border trading opportunities may raise concerns, however, that U.S.
investors may not receive sufficient disclosure about foreign markets or
foreign issuers and their securities. As foreign markets are made
increasingly accessible to U.S. investors through technological advances,
therefore, the Commission should examine how to ensure that investors will
======END OF PAGE 174======
receive sufficient information to make informed decisions.
B. Regulating Foreign Market Activities in the United States
The Commission's goal is to initiate a dialogue as to how to develop a
consistent, long-term approach that clarifies the application of the U.S.
securities laws to the U.S. activities of foreign markets. Any such
approach must not impose unnecessary regulatory costs on cross-border
trading and, at the same time, must allow the Commission to oversee foreign
markets' activities in the United States and protect U.S. investors under
the U.S. regulatory framework. There are several ways to achieve these
goals. As discussed below, for example, the Commission could (1) rely
solely on a foreign market's home country regulator; (2) require all
foreign markets to register as national securities exchanges or apply for
an exemption from registration; or (3) develop a tailored regulatory scheme
designed to regulate the entity that provides U.S. investors with the
ability to trade directly on foreign markets, rather than regulating the
foreign market itself. The Commission solicits comments on whether any
other alternatives could achieve the goals discussed above.
Question 105: What regulatory approaches would best address the
concerns raised by the development of automated access to foreign
markets? Would these approaches differ if U.S. investors accessed
foreign markets in ways other than those described above, such as
through the Internet? Are there any other alternative approaches that
could be more appropriate?
1. Sole Reliance on Foreign Markets' Home Country Regulation
One option could be for the Commission to rely solely on the laws of
the primary regulators of foreign markets, if those foreign markets are
======END OF PAGE 175======
subject to regulation comparable to U.S. securities regulation. Under this
approach, the Commission could specify foreign markets that it determines
are subject to comparable regulation. In determining whether a foreign
market is subject to comparable regulation, the foreign regulatory
structure could be viewed as a whole to determine whether it, in its design
and implementation, adequately addresses the key protections provided by
U.S. securities laws. The Commission could make this determination on a
case-by-case basis or it could establish certain standards governing the
determination. Under the latter approach, if a foreign market met those
enumerated standards, the foreign market could be considered subject to
"comparable" regulation.
This approach might have several advantages. First, it could provide
regulatory certainty to foreign markets entering the United States.
Second, it would not impose any additional regulatory costs on foreign
markets. As a result, foreign markets would be able to provide their
services to U.S. investors at lower cost. Third, this approach would
recognize that principles of international comity support reasonable
deference to a home country's governance of its own markets, particularly
with respect to trading in the securities of home country issuers.
Despite these advantages, an approach that relies solely on foreign
regulation has significant drawbacks. As discussed above, a U.S. investor
trading on a foreign market through an access provider may incorrectly
assume that such trading is subject to the same protections as trading on
It could be appropriate to permit foreign markets
regulated solely under the laws of their home
country to trade only foreign securities with U.S.
persons. Possible definitions of the term
"foreign securities" are discussed below.
======END OF PAGE 176======
U.S. markets. Foreign laws, however, may differ significantly from U.S.
securities laws. For example, under the federal securities
laws, a registered exchange must establish rules that describe its trading
processes, file those rules with the Commission (which publishes them for
comment), and enforce those rules fairly among its members. These
requirements are designed to enable investors to make informed decisions
about the risks and benefits of trading in a particular market. U.S.
investors rely on the availability and accuracy of the information provided
by markets, as well as the information provided by intermediaries, when
making their investment decisions. Many foreign markets, however, do not
require a similar level of disclosure.
The practices of foreign markets in areas that affect market integrity
can also differ significantly from those of U.S. exchanges. For example,
some foreign markets are not subject to laws designed to prevent insider
trading or other forms of market manipulation that are prohibited in the
United States. In addition, U.S. securities laws require market makers and
specialists to have firm quotes, and to display certain
customer limit orders. They also require U.S. markets and
certain participants to report most trades for public dissemination within
90 seconds. On the other hand, many foreign markets do not
See supra Section VII.A.2.
Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.
Pursuant to the terms of the CTA Plan, see supra
notes 166 and 167, it is the responsibility of all
participant exchanges and the NASD to report all
sales transactions as promptly as possible, and
(continued...)
======END OF PAGE 177======
require market participants to report trading activity as quickly as under
U.S. law, and do not publicly disseminate such information as
promptly as U.S. markets. Some foreign markets also do not require
companies to provide financial and other material information to investors
as often or as completely as is required under U.S. law. Moreover, the
methods of calculating and reporting financial information that are used on
foreign markets often differ from U.S. standards. U.S. investors trading
electronically on foreign markets from the United States may not have
access to complete information regarding these transaction reporting and
issuer disclosure practices so as to evaluate whether published information
is current.
Foreign markets also may not be subject to regulations designed to
provide regulators with the tools to detect and deter behavior that is
prohibited under U.S. securities laws, such as fraud, manipulation, or
insider trading. For example, unlike domestic exchanges, which are
required to comply with federal securities laws and to enforce compliance
(...continued)
establish collection procedures to ensure that 90%
of such last sale reports are provided within 90
seconds of execution. CTA Plan, Section VIII.
Market rules also require participants to report
trades within 90 seconds after execution or
designate them as being late. See, e.g., NASD
Rule 4632. A pattern or practice of late
reporting without exceptional circumstances may be
considered inconsistent with high standards of
commercial honor and just and equitable principles
of trade in violation of NASD Rule 2110.
Other foreign markets allow market participants to
delay reporting of certain trades. For example,
the London Stock Exchange allows members to delay
publication of certain large block trades for up
to 60 minutes.
======END OF PAGE 178======
with such laws by their members, foreign markets may have
less comprehensive surveillance, examination, or enforcement capabilities.
In addition, many foreign markets are not required under the laws of their
home countries to preserve the trading information that would enable an
investigation to be commenced under U.S. law. Without adequate
recordkeeping, it could be difficult for the Commission to detect
fraudulent or other illegal activity being conducted through access
providers.
An equally important component of the Commission's ability to detect
and investigate violations of the federal securities laws is access to
trading information. Even if a foreign market maintains comprehensive
trading records, it may be constrained by local law from sharing these
records or other market information with U.S. regulators.
Unless the Commission has access to trading records, its ability to fully
investigate and bring enforcement actions for violations of the U.S.
securities laws could be undermined.
U.S. investors may also expect that, because they are trading on
See supra Section II.B.1.
As the Commission staff stated in its 1994 report
on the U.S. equity markets, the Commission also
has a significant regulatory interest in ensuring
that foreign markets are not used by U.S. broker-
dealers to circumvent the application of U.S.
regulatory requirements to the detriment of U.S.
persons complying with those requirements. See
Market 2000 Study, supra note 14, at VII-4.
See generally Technical Committee of the
International Organization of Securities
Commissions (IOSCO), Report on Issues Raised for
Securities and Futures Regulators by Under-
Regulated and Uncooperative Jurisdictions 5 (Oct.
1994).
======END OF PAGE 179======
foreign markets from the United States, they will be able to file private
actions to recover losses arising from trading on those markets. In
reality, the foreign nature of such trading may prevent U.S. investors from
filing such claims in U.S. courts, from obtaining evidence to support their
claims, from serving process on defendants, or from enforcing judgments.
In sum, although relying on foreign market regulation could provide
regulatory certainty and allow foreign markets and access providers to
provide their services to U.S. investors, it may not provide U.S. investors
with certain essential protections they have come to expect. The
Commission seeks comment on whether this option is feasible and consistent
with the federal securities laws.
Question 106: If the Commission were to rely solely on a foreign
market's primary regulator, how could it address the investor
protection and enforcement concerns discussed above?
2. Requiring Foreign Markets to Register as National Securities
Exchanges
A second option could be to require foreign markets with U.S.
activities to register as national securities exchanges under the Exchange
Act or to satisfy criteria for exemption from exchange
registration. Foreign markets that offer their services to
U.S. persons would have to comply with the same regulatory obligations as
U.S. exchanges. Under this approach, U.S. investors trading on foreign
Currently, the only available exemption from
exchange registration is based on limited volume
of transactions. 15 U.S.C. 78(e). As discussed
in Section IV.B. above, however, the Commission is
soliciting comment on using its exemptive
authority under Section 36 of the Exchange Act to
create a new category of exempted exchanges.
======END OF PAGE 180======
markets would be provided with the same protections they have when trading
on U.S. markets. This could address the concern that, because trading on a
foreign market may be indistinguishable from trading on a domestic market,
investors may be led to expect that such trading would be subject to the
same protections provided by the U.S. securities laws. This approach also
could ensure that any foreign markets that offer services to U.S. investors
would provide the same protections as registered or exempted exchanges,
such as disclosure of trading rules, transparency, timely transaction
reporting, and T+3 clearance and settlement.
The U.S. regulatory scheme applicable to exchanges, however, is not
necessarily designed to accommodate entities that only engage in limited
activities in the United States and that are primarily regulated in foreign
jurisdictions. It may not be feasible, therefore, to regulate a foreign
market's activities under a regulatory scheme that applies to domestic
markets, particularly if a foreign market's only activity in the United
States is to provide its U.S. members with the ability to trade directly on
its facilities or to allow its members to provide U.S. persons with
electronic linkages to trade outside of the United States. For example,
U.S. exchange regulation could conflict with the regulation to which these
markets are already subject in their home countries or could subject these
markets to unnecessarily duplicative and expensive obligations. Any
approach to regulating the U.S. activities of these foreign markets should
attempt to minimize conflict with obligations imposed by their primary
regulators. There may also be limits on the Commission's jurisdiction to
impose exchange requirements on foreign markets that have remote access
arrangements with U.S. persons. The Commission seeks comment on whether
======END OF PAGE 181======
this option is feasible and consistent with the federal securities laws.
Question 107: Should the Commission require foreign markets with only
limited activities in the United States to register as national
securities exchanges or obtain an exemption from such registration?
How would this affect U.S. persons trading directly on foreign
markets?
3. Regulating Access Providers to Foreign Markets
A third approach could be to regulate the access providers to foreign
markets, including broker-dealers, rather than regulating the foreign
markets themselves. Entities that provide U.S. investors with the
technological capability to trade directly on a foreign market's facilities
appear to fall into two basic categories. The first category includes
those entities that distribute or publish information regarding
transactions on a foreign market, and provide a direct electronic link on
behalf of the U.S. members of that foreign market. This category of access
providers could be regulated as SIPs. Under this approach,
foreign markets, information vendors, and other parties that provide U.S.
members with the ability to trade directly on foreign markets could either
register as SIPs themselves, or could choose instead to have another
registered SIP provide this capability to U.S. persons. This approach
could also provide a safe harbor from exchange registration for foreign
markets regulated abroad that choose to conduct their limited U.S.
activities through a registered SIP.
See infra note 235 and accompanying text for a
discussion of the statutory definition of SIP.
Registered SIPs are required to comply with
Section 11A of the Exchange Act.
======END OF PAGE 182======
The second category of access providers consists of those U.S. and
foreign broker-dealers that provide U.S. persons who are not members of a
foreign market with the technological capability to trade directly on a
foreign market. Through their own or another broker-dealer's electronic
linkage to a foreign market, broker-dealer access providers enable their
customers to trade directly on the facilities of those foreign
markets. Because this access is provided in a manner that is
functionally equivalent to that provided by SIP access providers, it
presents the same risks to U.S. investors. Therefore, similar basic
requirements, such as recordkeeping, reporting, disclosure, and antifraud
requirements, could be applied to both SIP and broker-dealer access
providers.
Such an approach, based on the regulation of access providers, might
have several advantages over the two alternatives discussed above. First,
regulating only the U.S. activities of foreign markets and other entities
might reduce the likelihood of conflict with foreign markets' home country
regulations. Second, creating a regulatory framework tailored for foreign
markets could ensure appropriate protections for U.S. investors and clarify
the regulatory status of foreign markets and other entities with only
limited activities in the United States. Third, establishing a regulatory
structure that focuses on the limited activities occurring in the United
States, rather than on the activities that a foreign market or third party
conducts primarily in a foreign country, may be more consistent with the
A broker-dealer would not be considered an access
provider to a foreign market's trading facilities,
however, if it handled the execution of its
customer orders on foreign markets as part of its
traditional brokerage activities.
======END OF PAGE 183======
Commission's mandate under the Exchange Act. Finally, this
approach recognizes that U.S. investors trade directly on foreign markets
through a variety of sources, and could permit the Commission to regulate,
in a similar manner, all entities that provide this service.
Question 108: How can the Commission best achieve its goal of
regulating the U.S. activities of foreign markets? Commenters should
take into consideration that foreign markets are regulated abroad,
that there is a potential for international conflicts of law, and that
the Commission has jurisdictional limits. Given the difficulties of
surveilling public networks such as the Internet, would an access
provider approach be workable?
a. Access Providers to U.S. Members of Foreign Markets
Entities that provide U.S. members of foreign markets with the
technological capability to trade directly on these markets from remote
locations could be regulated as SIPs under Section 11A of the Exchange Act.
Section 11A was enacted by Congress more than twenty years ago to create a
statutory framework for the integration of automation into the securities
markets. Through this section, Congress sought to ensure
that "the securities markets and the regulations of the securities industry
remain strong and capable of fostering [the] fundamental goals [of the
Exchange Act] under changing economic and technological
conditions."
See generally 15 U.S.C. 78dd(b).
Section 11A of the Exchange Act was adopted as
part of the 1975 Amendments. Pub. L. No. 29, 89
Stat. 97 (1975).
S. Rep. No. 75, supra note 22, at 3.
======END OF PAGE 184======
While Congress did not focus on cross-border trading specifically,
Section 11A provides a regulatory basis to address changes in the markets
that result from the development of a global, electronic marketplace.
Section 11A extended the Commission's oversight authority to "any person
engaged in the business of (i) collecting, processing, or preparing for
distribution or publication, or assisting, participating in, or
coordinating the distribution or publication of, information with respect
to transactions in or quotations for any security . . . or (ii)
distributing or publishing . . . on a current and continuing basis,
information with respect to such transactions or quotations."
Congress gave the Commission authority to require such entities -- referred
to as SIPs -- to register with the Commission and to establish rules
governing SIP activities. All registered SIPs must carry out their
functions in a manner consistent with the Exchange Act and report to the
Commission denials or limitations of access to the services they provide.
The Commission has the authority to review those decisions in much the same
manner as it reviews denials or limitations of access to the services
offered by registered U.S. exchanges.
Because information processing and dissemination are critical
components of today's automated market, the definition of SIP potentially
covers a broad range of entities that facilitate communications among
investors, intermediaries, and markets. To date, however, only SIPs that
process information exclusively on behalf of a U.S. exchange or securities
Exchange Act 3(a)(22), 15 U.S.C. 78c(a)(22).
======END OF PAGE 185======
association (known as "exclusive processors") have been
required to register with the Commission. Congress exempted non-exclusive
SIPs from the Section 11A registration requirements until such time as the
Commission, by rule or order, finds that the registration of such non-
exclusive SIPs is necessary or appropriate in the public interest, for the
protection of investors, or for the achievement of the purposes of Section
11A. The Commission has not yet promulgated any such rules or
orders.
Exchange Act 3(a)(22)(B), 15 U.S.C. 78c(a)(22)(B).
An "exclusive processor" is any securities
information processor (which is defined in Section
3(a)(22)(A)) that:
directly or indirectly, engages on an exclusive basis
on behalf of any national securities exchange or
registered securities association or, any national
securities exchange or registered securities
association which engages on an exclusive basis on its
own behalf, in collecting, processing, or preparing for
distribution or publication any information with
respect to (i) transactions or quotations on or
effected or made by means of any facility of such
exchange or (ii) quotations distributed or published by
means of any electronic system operated or controlled
by such association.
Id.
Exchange Act 11A(b)(1), 15 U.S.C. 78k-1(b)(1). In
1975, the Commission adopted Rule 11Ab2-1 and Form
SIP, which provide that each SIP that is required
to be registered pursuant to Section 11A(b)(1) of
the Exchange Act (i.e., exclusive SIPs) must file
an application for registration on Form SIP.
Securities Exchange Act Release No. 11673 (Sept.
23, 1975), 40 FR 45448 (October 2, 1975).
Currently, there are five exclusive processors
registered under Section 11A: (1) the
Consolidated Tape Association, (2) the
Consolidated Quotation System, (3) the Securities
Industry Automation Corporation, (4) Nasdaq, and
(5) the Options Price Reporting Authority.
======END OF PAGE 186======
The Commission could use its authority to register and oversee non-
exclusive SIPs in order to establish a regulatory framework that could
accommodate U.S. investors' and intermediaries' participation in foreign
markets from the United States. For example, any non-exclusive SIP could
be required to register with the Commission under Section 11A if it met the
statutory definition of a SIP with respect to securities traded or approved
for trading on a foreign market and if it provided a facility or means
through which a U.S. person could transmit orders to a foreign market of
which the U.S. person is a member.
This approach may have several advantages. For example, it would
clarify the regulatory status of foreign markets that arrange for U.S.
investors to be members of their trading facilities from the United States.
As discussed above, several foreign markets have been reluctant to provide
U.S. persons with direct trading capability without receiving assurances
from the Commission that they would not be required to register as national
securities exchanges under Section 5 of the Exchange Act. If the
Commission's concerns regarding the effects of U.S. investors' direct
trading on foreign markets could be addressed through SIP regulation, there
might be no overriding interest in regulating these limited activities of
foreign exchanges in the United States under Section 5. The Commission
therefore solicits comment on the advantages of this approach. The
Commission is also soliciting comment on whether it would be appropriate to
create a "safe harbor" from exchange registration for bona
fide foreign markets that conduct all their securities
activities in the United States through a registered SIP.
See infra Section VII.B.1.c.(i).
======END OF PAGE 187======
Question 109: What would be the best way for the Commission to
regulate the limited U.S. activities of foreign markets that provide
remote access to U.S. members?
Question 110: When should an entity be required to register with the
Commission as a non-exclusive SIP under Section 11A of the Exchange
Act? For example, should the activities described above require
registration as a SIP?
Question 111: If the SIP approach were adopted, is it likely that
U.S. members of foreign markets would wish to transmit their orders to
such markets through more than one SIP registered with the Commission?
If so, should all but one of those SIPs be exempt from registration?
Question 112: Under the SIP approach, should foreign markets that
allow their U.S. members to transmit their orders solely through a
registered SIP have a safe harbor from registration as national
securities exchanges?
Question 113: What type of activities should a registered SIP be
permitted to conduct on behalf of a foreign market without the SIP or
the foreign market registering as an exchange?
b. Broker-Dealer Access Providers
A U.S. or foreign broker-dealer that provides U.S. persons with
terminals, software, access codes, or other means of directly trading on
the facilities of a foreign market through a member's interface with that
market, provides those U.S. persons with trading capabilities that are
functionally equivalent to those of market members, as described above.
These types of arrangements therefore present the same risks to U.S.
investors and investor protection concerns as described above. An example
======END OF PAGE 188======
of this type of arrangement is where a broker-dealer's customer is provided
with the technological capability to direct the execution of its orders by
viewing a foreign exchange's central limit order book and then
transmitting, modifying, or subsequently cancelling an order based on the
information in the limit order book. Although the customer's
trading on the foreign exchange may be technically or legally considered to
be routed by the foreign market member, the customer has the ability to use
the facilities of the exchange as though it were a member. By providing
U.S persons with the capability to transmit directly, and to direct the
execution of, orders to a foreign market, the broker-dealer is providing
services that go beyond traditional brokerage services.
Because these services are a relatively recent development, it appears that
only a small number of registered broker-dealers provide this type of
direct automated service to their institutional customers.
In view of these developments, it may be appropriate to regulate, in the
manner just described for SIP access providers, both foreign and U.S.
This type of arrangement is commonly referred to
in this context as a broker-dealer "give-up."
This type of electronic "pass-through" arrangement
would not encompass customer orders executed on
foreign markets by broker-dealers on behalf of
their customers as part of a broker-dealers'
traditional brokerage activities.
The principal additional requirement with which
registered broker-dealers that are access
providers to foreign markets would have to comply
under this type of approach, would be disclosure
of the specific risks relating to the trading on
foreign markets. Registered broker-dealers are
already subject to most of the recordkeeping,
reporting, and antifraud requirements discussed in
Section VII.B.1.c.(iii).
======END OF PAGE 189======
broker-dealers that provide U.S. persons with access to an automated
facility or means through which they can directly transmit, and direct the
execution of, orders on a foreign market.
In some cases, broker-dealers provide their customers with this type
of direct linkage to U.S. exchanges through systems such as the NYSE's
SuperDOT system. Although a U.S. exchange has obligations
under the federal securities laws and is subject to Commission oversight, a
foreign market does not have similar obligations. The ability to trade
directly on foreign markets, therefore, may raise investor protection
concerns.
U.S. registered broker-dealers are also subject to a panoply of
regulations and supervisory requirements intended to protect both the
capital markets and investors, and have general agency
obligations to their customers under the federal securities laws.
Nevertheless, these requirements, in their current form, do not necessarily
address concerns raised when broker-dealers provide automated means for
U.S. persons to trade directly on foreign markets. Consequently, the
Commission could separately regulate the activities of U.S. broker-dealers
that act as access providers.
See supra note 16.
For example, a broker-dealer is required to
register with the Commission, become a member of
an SRO and SIPC, maintain certain minimum levels
of net capital, segregate customer funds, maintain
certain books and records, and make periodic
reports to the Commission. In addition, broker-
dealers are subject to statutory disqualification
standards and the Commission's disciplinary
authority. See Exchange Act 15, 15 U.S.C. 78o;
Securities Investor Protection Act of 1970, 15
U.S.C. 78aaa. See also 17 CFR 240.15a-6.
======END OF PAGE 190======
Foreign broker-dealers that engage in activities as broker-dealer
access providers are, in most cases, exempt from broker-dealer registration
pursuant to Rule 15a-6 under the Exchange Act. These access
providers therefore are not subject to the same requirements under the U.S.
securities laws as registered broker-dealers. The question thus arises of
whether the Commission should require foreign broker-dealers to register as
U.S. broker-dealers if they act as access providers to foreign markets on
behalf of U.S. persons. Traditional broker-dealer regulation could subject
foreign broker-dealers to requirements that are not necessary to address
concerns raised by the activities of access providers. Such requirements
could include the maintenance of specified capital, and SIPC and SRO
membership. Under an approach that applied to broker-dealer access
providers, however, the Commission could subject foreign broker-dealers
that enable U.S. investors to trade directly on foreign markets to a
regulatory framework tailored to their access provider activities.
Question 114: What types of automated broker-dealer systems, both
operational and contemplated, would be encompassed within the above
description of access providers to foreign markets? How widespread
are these activities?
Question 115: Would the above description of broker-dealer access
providers adequately and clearly exclude traditional brokerage
activities, particularly handling the execution of customer orders on
foreign markets? If not, how should such activities be distinguished
This release does not address any issues that may
be raised regarding the applicability of Rule 15a-
6 under the Exchange Act or a foreign broker-
dealer's obligations thereunder. 17 CFR 240.15a-
6.
======END OF PAGE 191======
from traditional brokerage activities, particularly traditional cross-
border activities? Should U.S. broker-dealers that provide investors
with access to foreign markets be subject to any additional
requirements?
Question 116: Should foreign broker-dealers that provide U.S.
investors with automated access to foreign markets be required to
register as broker-dealers on the basis of that activity?
c. Requirements Applicable to Access Providers
If the Commission were to regulate foreign market access providers,
there are a number of conditions that could be applied to these entities.
For example, as discussed further below, the Commission could subject
registered SIP and broker-dealer access providers to recordkeeping,
reporting, disclosure, or antifraud requirements.
Question 117: What types of conditions, if any, should the Commission
place on access providers if it were to pursue that approach?
(i) Conditions Relating to the Type of Foreign Market
Any new regulatory approach developed by the Commission to address the
unique concerns raised by access providers would not be intended as an
alternative regulatory scheme for U.S. exchanges. Accordingly, any such
approach would be applicable only to bona fide foreign markets. There are
a variety of ways the Commission could define a bona fide foreign market.
For example, a bona fide foreign market could be any entity that meets the
definition of an exchange under Section 3(a)(1) of the Exchange Act or that
otherwise conducts the business of an exchange, but that is organized and
has its principal place of business outside of the United States. Any
national securities exchange, national securities association, or exchange
======END OF PAGE 192======
exempt from registration pursuant to a Commission rule or order would not
be considered a bona fide foreign market. The Commission could also
exclude from the definition of a bona fide foreign market an exchange that
operates a trading facility or provides terminals in the United States.
Another issue is whether SIP and broker-dealer access providers should
be permitted to transmit orders for U.S. persons only to foreign markets
that would be able to share information with the Commission in connection
with an investigation. As discussed above, the ability to access trading
and other market information is an essential component of the Commission's
ability to detect and deter fraud. Therefore, the Commission could require
a level of information sharing that could ensure that the Commission has
the ability to obtain necessary information from a foreign regulatory
authority and to obtain meaningful assistance in the case of fraud or
manipulation involving U.S. persons and a foreign market's
participants. For example, the Commission could require
access providers to enter into private contractual agreements with foreign
markets to which orders are transmitted, under which foreign markets
represent that they are not prohibited by local law from sharing
information with the Commission and, as a condition of registration, agree
to provide information to the Commission upon request. Alternatively, the
Some U.S. exchanges that trade derivative products
based on securities primarily traded on foreign
markets already have surveillance sharing
agreements in place. These surveillance sharing
agreements typically require signatories to
provide to each other, upon reasonable request,
information about market trading activity,
clearing activity, and, in some instances, the
identities of the purchasers and sellers of
securities.
======END OF PAGE 193======
Commission could designate certain foreign markets that, in its experience,
are able to share information with the Commission.
Question 118: If the Commission decides to regulate access providers
to foreign markets, what criteria should the Commission use in
determining whether an exchange is a bona fide foreign market? Should
a market be required to have at least a majority of foreign members in
order to be a bona fide foreign market? Should the Commission exclude
exchanges that provide terminals in the United States?
Question 119: Should the Commission regulate as a U.S. exchange any
market that, although organized and having its principal place of
business outside of the United States, is under common control with or
controlled by U.S. persons, or whose decisions regarding trading
rules, practices, or procedures are made by U.S. persons?
Question 120: What factors should the Commission use in determining
whether an exchange is operating a trading facility in the United
States and is not a bona fide foreign market? If exchange-owned
terminals are located in the United States, should this constitute
operating a trading facility in the United States?
Question 121: What effect would a reinterpretation of the term
"exchange" under Section 3(a)(1) of the Exchange Act have on any
Commission proposal to regulate SIP and broker-dealer access
providers?
Question 122: If the Commission decides to regulate access providers
to foreign markets, should the Commission require access providers to
transmit orders only to foreign markets that are willing to share, and
capable of sharing, information with the Commission in connection with
======END OF PAGE 194======
investigations involving violations of U.S. securities laws? If so,
what standard should the Commission use in determining whether a
foreign market would provide meaningful assistance to the Commission?
If commenters believe that SIP and/or broker-dealer access providers
should be permitted to transmit orders to any foreign market, indicate
how the Commission could ensure that it has the ability to enforce the
applicable provisions of the federal securities laws.
Question 123: Should the Commission require access providers to
transmit orders only to foreign markets that are located in countries
that have entered into arrangements with the Commission to provide
enforcement and information sharing assistance?
(ii) Conditions Relating to Type of Persons and
Securities
Access providers could be limited to providing their services only to
certain sophisticated U.S. institutional investors. Another alternative
could be to permit broker-dealer access providers to provide their services
to all U.S. investors, but restrict the type of investors to which SIP
access providers could provide their services. The Commission is
soliciting comment on whether both SIP and broker-dealer access providers
should provide their services only to certain sophisticated U.S.
institutional investors. In addition, the Commission solicits comment on
whether the additional customer protection requirements to which registered
broker-dealers are subject should mean that broker-dealer access providers
should be allowed to provide their services to all U.S. investors.
Another issue to be considered is whether it would be appropriate to
permit SIP and broker-dealer access providers to transmit orders from U.S.
======END OF PAGE 195======
persons to foreign markets only for foreign securities. On the whole,
transactions in securities of domestic issuers have a greater potential to
affect the U.S. securities markets than transactions in securities of non-
U.S. issuers, where the primary market is typically overseas. Moreover,
when a U.S. access provider is used to trade the securities of domestic
issuers on a foreign market, the foreign market could be required to
register as a U.S. exchange under Section 5 of the Exchange
Act.
Question 124: If the Commission regulated access providers through
the approach described above, should SIP access providers be limited
to providing their services to sophisticated institutions or should
they be allowed to provide any U.S. investor with the capability of
directly trading on foreign markets as members? If so, should broker-
dealer access providers be subject to similar requirements?
Question 125: If the Commission permits SIP access providers to offer
their services only to broker-dealers and certain sophisticated
institutions, how should this category of sophisticated institutions
be defined?
Question 126: Should the Commission permit SIP and broker-dealer
U.S. courts have interpreted the extraterritorial
application of the Exchange Act more expansively
when the securities that are the subject of the
transaction are issued by a U.S. corporation. See
ITT v. Cornfeld, 619 F.2d 909 (2d Cir. 1980); ITT
v. Vencap, Ltd., 519 F.2d 1001, 1017 (2d Cir.
1975) ("We believe that Congress intended the
Exchange Act to have extraterritorial application
in order . . . to protect the domestic securities
market from the effects of improper foreign
transactions in American securities.") (quoting
Schoenbaum v. Firstbrook, 405 F.2d 215, 206 (2d
Cir. 1968)).
======END OF PAGE 196======
access providers to transmit orders to foreign markets for the
securities of U.S. issuers or only for the securities of non-U.S.
issuers?
Question 127: Should the Commission limit the ability of SIP and
broker-dealer access providers to transmit orders to foreign markets
for the securities of non-U.S. issuers if the "principal market" for
those securities is located in the United States? If so, how should
the Commission determine when the "principal market" of a non-U.S.
security is located in the United States?
Question 128: If the Commission permits SIP and broker-dealer access
providers to transmit orders to foreign markets only for securities of
non-U.S. issuers, how should the Commission distinguish between U.S.
and non-U.S. issuers?
(iii) Recordkeeping, Reporting, Disclosure, and
Antifraud Requirements
Recordkeeping and reporting requirements, generally, are an important
component of the Commission's oversight role. Adequate trading records are
invaluable to the Commission's efforts to enforce the antifraud provisions
of the Exchange Act. Without adequate records and reports, the Commission
would be unable to effectively monitor, evaluate, and examine the
activities of registered SIP and broker-dealer access providers.
If the Commission decides to adopt a regulatory framework for access
providers, such recordkeeping and reporting requirements could be crucial
elements in enhancing Commission oversight of their activities, and in
identifying areas where surveillance is needed to detect fraudulent,
deceptive, and manipulative practices. Records and periodic reports could
======END OF PAGE 197======
also assist the Commission in gaining an understanding of the effects of
foreign markets' activities in the United States and with U.S. persons.
For example, these recordkeeping and reporting requirements could be
similar to the requirements currently imposed on broker-dealers under
Exchange Act Rule 17a-23. Specifically, the Commission could
require access providers to keep (i) records regarding the identity of
their U.S. users; (ii) records regarding daily summaries of trading and
time-sequenced records of each transaction effected through the access
provider; (iii) information disseminated to U.S. investors, such as
quotation and transaction information regarding foreign securities traded
on foreign markets; and (iv) copies of the membership standards used by
each foreign market to which the SIP provides the U.S. members of the
market with the ability to trade directly.
In addition, access providers could be required to file periodic
reports. Such periodic reports could contain information regarding (i) the
types of securities for which orders are transmitted; (ii) the names of
users of the access provider; and (iii) certain transaction information,
such as the total volume, number, and monetary value of transactions for
each foreign market to which orders are transmitted.
If certain entities that provide U.S. investors with the ability to
trade directly on foreign markets were required to register as SIPs, they
would, by operation of Section 11A of the Exchange Act, be required to
notify the Commission, and the Commission would be required to review, any
17 CFR 240.17a-23. To the extent that an access
provider that is a U.S. broker-dealer is already
subject to Rule 17a-23, that access provider would
not be subject to duplicative requirements.
======END OF PAGE 198======
limitations or prohibitions of access to the services offered by such
SIPs. Pursuant to Section 11A, the Commission would be
required to set aside any action only if it determined that such action was
unfairly exclusionary.
In addition to recordkeeping and reporting requirements, the
Commission is soliciting comment on whether access providers could be
required to make certain disclosures to U.S. investors. Disclosure has
always been a cornerstone of the Commission's efforts to protect investors.
The question becomes what types of specific disclosures are needed to
ensure that U.S. persons have sufficient information regarding foreign
securities traded on a particular foreign market through an access
provider. For example, SIP and broker-dealer access providers could be
required to disclose information about the material risks of trading on
foreign markets, as well as the risks of using their own facilities. Such
disclosure could include information about trading priorities on a foreign
market and notification that the nature and timeliness of pre-trade and
post-trade information provided by a foreign market differs from that
Exchange Act 11A(b)(5), 15 U.S.C. 78k-1(b)(5).
The Senate Committee on Banking, Housing and Urban
Affairs report on the Securities Acts Amendments
of 1975 indicates that one of the purposes of
expanding the Commission's regulatory authority
over the processors and distributors of market
information was "to assure that these
communications networks are not controlled or
dominated by any particular market center, to
guarantee fair access to such systems . . . and to
prevent any competitive restriction on their
operation not justified by the purposes of the
Exchange Act." S. Rep. No. 75, 94th Cong., 1st
Sess. 9 (1975). Under Section 11A(b)(5)(A) of the
Exchange Act, registered SIPs are required to file
notices of denial or limitation of access with the
Commission. 15 U.S.C. 78k-1(b)(5)(A).
======END OF PAGE 199======
provided by U.S. registered securities exchanges. In addition, access
providers could be required to disclose that there is no guarantee under
U.S. law that clearance or settlement of securities trades will occur. SIP
and broker-dealer access providers could also be required to disclose
system-related risks, including limitations affecting the access providers'
capacity to disseminate timely information or to handle users' orders
during peak periods.
The Commission could also consider specific antimanipulation rules for
registered SIP and broker-dealer access providers in order to clarify the
obligations imposed upon these entities under the antifraud provisions of
the federal securities laws. The Commission has promulgated rules
applicable specifically to registered broker-dealers that prohibit them
from engaging in manipulative, deceptive, or other fraudulent
activities. It would initially appear that SIP and broker-
dealer access providers should be similarly prohibited from engaging in
fraudulent, deceptive, or manipulative activities. For this reason, the
Commission could consider the need for rules supplementing the general
prohibition against fraud in Section 10(b) of the Exchange Act, and Rule
10b-5 thereunder. For example, it could specifically
prohibit access providers from distributing or publishing information that
they have reasonable grounds to believe is fraudulent, deceptive, or
manipulative, or from colluding to promote certain stocks without the
knowledge of U.S. investors.
Question 129: If the Commission decides to regulate access providers
See 17 CFR 240.15c1-2 through 240.15c1-9.
15 U.S.C. 78j(b); 17 CFR 240.10b-5.
======END OF PAGE 200======
to foreign markets, should they be required to make and keep records?
What records should registered SIP and broker-dealer access providers
be required to maintain?
Question 130: Should access providers be required to file periodic
reports? If so, what information should those contain?
Question 131: Should broker-dealer access providers be required to
keep records of denials of access to their services? Should they be
required to notify the Commission of such denials of access?
Question 132: What types of risks should be disclosed to users of SIP
and broker-dealer access providers? For example, should SIP and
broker-dealer access providers be required to disclose the listing and
maintenance standards of foreign markets to which they transmit orders
on behalf of U.S. persons? What would be the costs associated with
such a requirement?
Question 133: Should access providers be required to make disclosures
to sophisticated institutions?
Question 134: What market information should SIP and broker-dealer
access providers be required to provide to the users of their
services?
C. Addressing the Differences Between U.S. and Foreign Markets'
Listed Company Disclosure Standards
As the Commission develops an approach to the appropriate regulation
of the U.S. activities of foreign markets, it must also address the issues
that arise because most securities traded on foreign markets are not
registered under the Securities Act or the Exchange Act, and the issuers of
those securities do not file reports with the Commission. Section 5 of the
======END OF PAGE 201======
Securities Act makes it unlawful for any person, through the use of
interstate commerce or the mails, to offer or sell a security in a public
distribution prior to the effective date of the registration
statement. Unless an exemption applies, securities offered
or sold in the United States by issuers (whether domestic or foreign) must
be registered with the Commission pursuant to Section 5 of the Securities
Act. In some cases, foreign securities issued abroad, but
later sold in the United States, may be eligible for the exemption under
Section 4(1) of the Securities Act for "transactions by any person, other
than an issuer, underwriter or dealer." However, to the
extent that a foreign issuer effects a distribution over the facilities of
a foreign market, SIP access providers to that market could be required to
ensure that U.S. investors may not purchase that security during the
distribution, absent registration or an available exemption under the
Securities Act. Similarly, the Commission requests comment on whether
broker-dealer access providers should be required to ensure that U.S.
investors do not purchase the securities of a foreign issuer effecting a
distribution on a foreign market, unless there is an effective registration
Securities Act 5, 15 U.S.C. 77e.
For example, Section 3(a) of the Securities Act
enumerates 12 categories of exempted securities to
which the registration requirements of Section 5
do not apply, including securities issued by the
U.S. Government, religious and benevolent
organizations, savings and loan associations, and
cooperative banks. 15 U.S.C. 77c(a). Securities
of foreign private and sovereign issuers are not
exempted securities. In addition, Section 4 of
the Securities Act sets forth a number of exempted
transactions. 15 U.S.C. 77d.
Securities Act 4(1), 15 U.S.C. 77d(1).
======END OF PAGE 202======
statement or an applicable exemption.
As noted, U.S. investors historically have been able to purchase
unregistered securities traded on foreign markets by placing orders through
one or more domestic and foreign broker intermediaries, which in turn have
direct or indirect access to the foreign exchange or market. U.S. and
foreign broker-dealers are today providing certain U.S. investors with
automated links to foreign markets. As technology facilitates the ability
of U.S. investors to conduct transactions directly on foreign securities
exchanges and markets, the distinctions between the domestic and foreign
trading markets may quickly disappear.
In the Exchange Act, Congress has set the threshold for requiring
registration and reporting either upon a company's listing on a U.S.
exchange or, in the case of a class of equity securities,
upon having at least 500 record holders (in the case of foreign issuers,
300 of which are in the United States) and assets over a specified dollar
amount. These disclosure requirements provide transparency
with respect to the business, management, operating results and financial
condition of the issuers of the traded securities. This is different from
the market transparency provided by the Commission's regulatory and
disclosure requirements applicable to markets and their members.
The Commission has accommodated the legitimate interest of foreign
issuers whose shares come to be held in the United States by providing an
Section 12(a) of the Exchange Act.
Section 12(g) of the Exchange Act, 15 U.S.C.
78l(g), and Rules 12g-1 and 12g3-2(a), 17 CFR
240.12g-1 and 240.12g3-2(a).
======END OF PAGE 203======
exemption from registration under Exchange Act Rule 12g3-2(b)
if those shares are not listed on a U.S. exchange or quoted on Nasdaq and
if the issuer has not registered an offering of securities under the
Securities Act. These issuers need not register so long as they provide
the Commission with the information that they make available to their
securityholders in their home countries. The exemption is grounded in the
jurisdictional and comity concerns that the Commission could not require a
foreign company to register and file reports if the company has not
affirmatively taken steps to enter our markets, regardless of the level of
interest by U.S. investors in the company's securities.
These concerns directly relate to issues raised by the extensive
trading in this country of unregistered foreign securities in the U.S.
over-the-counter markets, bulletin boards, and alternative trading systems.
Despite the extensive U.S. ownership and trading in these foreign
securities, registration under the Exchange Act is not required by virtue
of the Rule 12g3-2(b) exemption.
As noted in Section IV.B., if the Commission decides to regulate
certain domestic alternative trading systems as exchanges, foreign
securities traded on those exchanges would have to be registered. By
excluding foreign markets from the definition of exchange, however, absent
Commission action, Rule 12g3-2(b) would continue to provide an exemption
for the foreign issuers of the securities traded on those markets from
registration under the Exchange Act. By facilitating U.S. investor access
to foreign markets, the SIP or broker-dealer approach described above could
promote a real time market in the United States for the securities of
17 CFR 240.12g3-2(b).
======END OF PAGE 204======
potentially thousands of foreign companies without those companies meeting
U.S. disclosure and accounting standards. The question thus becomes
whether the access provided by SIPs to trading in foreign markets should be
limited to securities that are registered with the Commission pursuant to
Section 12 of the Exchange Act. In addition, there is a question as to
whether the Commission should also limit broker-dealer access providers to
providing U.S. investors with access to securities trading in foreign
markets that are registered under Section 12, or whether a distinction
should be made between SIP access providers and broker-dealer access
providers. The Commission is soliciting comment on whether the approach
described above adequately protects the interests of U.S. investors.
Question 135: Should direct trading in foreign listed companies be
limited to those that satisfy U.S. disclosure standards in order to
better protect U.S. investors?
Question 136: Is it sufficient to merely disclose to investors that
the information available about a foreign security may significantly
differ from the information that would be available about U.S.
securities? Do public policy concerns dictate that the Commission
make distinctions based on whether investors receive adequate
information?
Question 137: Are there circumstances under which unregistered
foreign securities should be permitted to trade on foreign markets
through an access provider? For example, should the Commission
establish some de minimis threshold for a foreign security based on
the dollar value of the U.S. float or trading volume in that security,
or on the relative percentage of U.S. float or trading volume compared
======END OF PAGE 205======
to that of the home or worldwide markets?
Question 138: Should the exemption from registration under Exchange
Act Rule 12g3-2(b) be available if a significant portion of an
issuer's float is traded in the United States?
Question 139: Given that broker-dealers currently trade unregistered
securities for customers, should the Commission reconsider its
approach to securities registration requirements in this context? Are
there other viable alternatives that would ensure adequate disclosure
to U.S. investors trading on foreign markets?
Question 140: Is trading in unregistered foreign securities through
an access provider to a foreign market appropriate if access is
limited to sophisticated investors? For example, should access
providers be permitted to transmit orders for unregistered foreign
securities to a foreign market on behalf of qualified institutional
buyers as defined in Rule 144A of the Securities Act?
Question 141: Are there uniform procedures that the Commission should
impose on foreign markets or on access providers to assure that
securities are not sold to U.S. investors in circumstances that result
in a public distribution of securities in the United States that are
not registered under the Securities Act?
Question 142: What are the consequences to SEC reporting companies if
unregistered foreign securities listed on foreign markets are
available to be purchased or sold through access providers?
D. Costs and Benefits of Revising Regulation of Foreign Market
Activities in the United States
Direct U.S. investor access to foreign markets could provide
======END OF PAGE 206======
significant benefits to U.S. investors. Such access may provide these
investors with entirely new investment opportunities, and may significantly
reduce their transaction costs. The Commission generally solicits comment
on the expected costs and benefits of the three alternative approaches to
regulating the activities of foreign markets in the United States, as
discussed above.
E. Conclusion
The increasing globalization of the securities markets has created new
opportunities for U.S. investors. The establishment of new securities
markets coupled with the enhancement of corporate disclosure and trade
transparency in many stock exchanges throughout the world has dramatically
increased their range of viable investment opportunities. At the same
time, advancements in technology have made foreign investment opportunities
more accessible and affordable to U.S. investors. Although these are
positive developments, they also raise concerns that the activities of
foreign markets in the United States could adversely affect not only U.S.
investors, but also the U.S. securities markets.
The Commission believes it is critical to address the regulatory
issues raised by U.S. investors' use of technology to trade directly on
foreign markets. The Commission hopes to develop a consistent, long-term
approach to address these issues, while ensuring that key protections for
U.S. investors, as well as U.S. markets, are in place. Discussed above are
three alternatives. The Commission is seeking comment on each of these
alternatives, along with commenters' ideas about other viable alternatives.
Question 143: Would any of the approaches described above provide an
======END OF PAGE 207======
effective means of addressing the issues raised by foreign market
activities in the United States, including providing key protections
for U.S. investors? What would be the benefits of each approach?
What would be the drawbacks of each approach?
VIII. Summary of Requests for Comment
Following receipt and review of comments, the Commission will
determine whether rulemaking or other action is appropriate. Commenters
are invited to discuss the broad range of concepts and approaches described
in this release concerning the Commission's registration and oversight of
national securities exchanges, alternative trading systems, and foreign
market activities in the United States. In addition to responding to the
specific questions presented in this release, the Commission encourages
commenters to provide any information to supplement the information and
assumptions contained herein regarding the functioning of secondary
markets, the roles of market participants, the advantages and disadvantages
of the suggested reforms, the expectations of investors, and cross-border
trading. The Commission also invites commenters to provide views and data
as to the cost and benefits associated with possible changes discussed
above in comparison to the costs and benefits of the existing statutory
framework. In order for the Commission to assess the impact of changes to
the Exchange Act's regulatory scheme, comment is solicited, without
limitation, from investors, broker-dealers, exchanges, and other persons
involved in the securities markets. In sum, the Commission requests
comment on the following questions:
Question 1: The Commission seeks comment on the concerns identified above
and invites commenters to identify other issues raised by the current
======END OF PAGE 208======
approach to regulating alternative trading systems.
Question 2: Are the concerns raised in this release with regard to the
operation of alternative trading systems under the current regulatory
approach unique to such systems? To what extent could these concerns be
raised by broker-dealers that do not operate alternative trading systems,
such as a broker-dealer that matches customer orders internally and routes
them to an exchange for execution or a broker-dealer that arranges for
other broker-dealers to route their customer orders to it for automated
execution?
Question 3: What regulatory approaches would best address the concerns
raised by the growth of alternative trading systems and the needs of the
market? Is the current approach the most appropriate one?
Question 4: What should be the objectives of market regulation? Are the
goals and regulatory structure incorporated by Congress in the Exchange Act
appropriate in light of technological changes? Are business incentives
adequate to accomplish these goals?
Question 5: Are the regulatory categories defined in the Exchange Act
sufficiently flexible to accommodate changes in market structure? If not,
what other categories would be appropriate? How should such categories be
defined?
Question 6: Can the Commission regulate markets effectively through
standard-oriented regulation of the type described above?
Question 7: How could the Commission enforce compliance with the Exchange
Act under such a standard-oriented approach?
Question 8: Is the current regulatory framework an effective form of
oversight, in light of technological changes? Are there other regulatory
======END OF PAGE 209======
techniques that would be comparably effective? If so, would the
implementation of such techniques be consistent with congressional goals
reflected in the Exchange Act?
Question 9: Are there viable alternatives within the existing Exchange Act
structure, other than those discussed below, that would address the
concerns raised by the growth of alternative trading systems and
congressional goals in adopting the Exchange Act?
Question 10: What types of alternative trading systems would it be
appropriate to regulate in this manner?
Question 11: If the Commission decided to further integrate alternative
trading systems into the NMS through broker-dealer regulation, should it
require alternative trading systems to submit all orders displayed in their
systems into the public quotation system? If not, how should the
Commission ensure adequate transparency?
Question 12: If the Commission requires alternative trading systems to
submit all orders displayed in their systems into the public quotation
system, how can duplicate reporting by alternative trading systems and
their participant broker-dealers be prevented?
Question 13: Are there other methods for integrating all orders submitted
into alternative trading systems into the public quotation system?
Question 14: Are there any reasons that orders available in alternative
trading systems should not be available to the public?
Question 15: If the Commission requires alternative trading systems to
allow non-participants to execute against orders of system participants,
how should it ensure that non-participants are granted equivalent access?
Question 16: If the Commission requires alternative trading systems to
======END OF PAGE 210======
allow non-participants to execute against orders of system participants,
how should it determine whether the fees charged to non-participants by
such systems are reasonable and do not have the effect of denying access to
orders?
Question 17: Are there any reasons that non-participants should not be
able to execute against orders of participants in alternative trading
systems?
Question 18: Should the Commission require alternative trading systems to
provide additional information (such as identifying counterparties) to
their SRO in order to enhance the SRO's audit trail and surveillance
capabilities?
Question 19: What other methods could the Commission use to enhance market
surveillance of activities on alternative trading systems?
Question 20: Should SROs be required to surveil trading by their members
in securities that are not listed or quoted on the market operated by that
SRO?
Question 21: Should alternative trading systems be required to follow
guidelines regarding the capacity and integrity of their systems? If not,
how should the Commission address systemic risk concerns associated with
potentially inadequate capacity of alternative trading systems,
particularly those systems with significant volume?
Question 22: With what types of standards regarding computer security,
capacity, and auditing of systems, should alternative trading systems be
required to comply?
Question 23: To what extent would complying with systems guidelines
similar to those implemented by exchanges and other SROs require
======END OF PAGE 211======
modification to the current procedures of alternative trading systems?
What costs would be associated with such modifications? How much time
would be required to implement the necessary modifications and systems
enhancements? Please provide a basis for these estimates.
Question 24: Is access to alternative trading systems an important goal
that the Commission should consider in regulating such systems? If so, are
there circumstances in which alternative trading systems should be able to
limit access to their systems (for example, should the Commission be
concerned about access to an alternative trading system that has arranged
for its quotes to be displayed as part of the public quotation system)?
Question 25: If alternative trading systems were to continue to be
regulated as broker-dealers and were subject to a fair access requirement,
should the Commission consider denial of access claims brought by
participants and non-participants in alternative trading systems? If not,
are there other methods that could adequately address such claims?
Question 26: Are commenters aware of any unfair denials of access by
broker-dealers operating alternative trading systems, where there were no
alternative trading venues available to the entities denied access?
Question 27: Would enhanced surveillance of alternative trading systems by
their SROs raise competitive concerns that could not be addressed through
separation of the market and regulatory functions of the SROs?
Question 28: If alternative trading systems continue to be regulated as
broker-dealers, are there other ways to integrate the surveillance of
trading on alternative trading systems?
Question 29: What is the feasibility of establishing an SRO solely for the
purpose of surveilling the trading activities of broker-dealer operated
======END OF PAGE 212======
alternative trading systems, that does not also operate a competing market?
Question 30: If alternative trading systems continue to be regulated as
broker-dealers, how can the Commission address anticompetitive practices by
such systems?
Question 31: Would this approach be an effective means of addressing the
issues raised by the growth of alternative trading systems? What would be
the benefits of such an approach? What would be the drawbacks of such an
approach?
Question 32: If the Commission reinterpreted the term "exchange," are the
factors described above (i.e., (1) consolidating orders of multiple parties
and (2) providing a facility through which, or setting conditions under
which, participants entering such orders may agree to the terms of a trade)
sufficient to include the alternative trading systems described above?
Question 33: Is broadening the Commission's interpretation of "exchange"
to cover diverse markets, and then exempting all but the most significant
of these new exchanges from registration, the most appropriate way to
address the regulatory gaps discussed above and provide the Commission with
sufficient flexibility to oversee changing market structures?
Question 34: Are there any other categories of alternative trading systems
that have sufficiently minimal effects on the public secondary market that
they should be treated as exempted exchanges?
Question 35: Should low impact markets be regulated as exempted exchanges,
rather than as broker-dealers?
Question 36: What measure or measures should be used in determining
whether a market has a low impact? What is the level above which an
alternative trading system should not be considered to have a low impact on
======END OF PAGE 213======
the market? At what level should an already registered exchange be able to
deregister?
Question 37: Should an alternative trading system be considered to have a
low impact on the market and be treated as an exempted exchange if it
trades a significant portion of the volume of one security, even if the
trading system's overall volume is low in comparison to the market as a
whole?
Question 38: In determining whether an alternative trading system has a
low impact, what factors other than volume should the Commission consider?
Should this determination be affected if the operator of an alternative
trading system was the issuer of securities traded on that system?
Question 39: Should passive markets be regulated as exempted exchanges,
rather than as broker-dealers?
Question 40: Are the requirements described above appropriate to ensure
the integrity of secondary market oversight?
Question 41: Should any other requirements be imposed upon exempted
exchanges, such as requirements that an exempted exchange provide fair
access or establish procedures to ensure adequate system capacity,
integrity, and confidentiality?
Question 42: Should requirements vary with the type of alternative trading
system (e.g., should passive systems be subject to different conditions
than systems exempted on the basis of low impact)?
Question 43: Should the Commission require that securities traded on
exempted exchanges be registered under Section 12 of the Exchange Act?
Should different disclosure standards be applicable to such securities if
they are only traded on such exchanges?
======END OF PAGE 214======
Question 44: Should the Commission allow institutions to be participants
on registered exchanges to the same extent as registered broker-dealers?
If so, should the Commission adopt rules allowing registered exchanges to
have institutional participants, or should the Commission issue exemptive
orders on a case-by-case basis, upon application for relief by registered
exchanges?
Question 45: Should the Commission allow exchanges to provide services
exclusively to institutions?
Question 46: If the Commission allows institutions to participate in
exchange trading, should the Commission view all entities that have
electronic access to exchange facilities as "members" under the Exchange
Act and then exempt exchanges from Section 6(c)(1)?
Question 47: Is it foreseeable that exchanges will wish to permit retail
investors to be participants in their markets? If so, should the
Commission allow retail participation on registered exchanges to the same
extent as registered broker-dealers?
Question 48: Should the Commission allow registered exchanges to provide
services exclusively to retail investors?
Question 49: Could exchanges have various classes of participants, as long
as admission criteria and means of access are applied and allocated fairly?
Would it be in the public interest if new or existing exchanges sought to
operate primarily or exclusively on a retail basis? What would be the
advantages and disadvantages if new or existing exchanges were to admit as
participants only highly capitalized institutions or only highly
capitalized institutions and broker-dealers?
Question 50: Should non-membership exchanges (including alternative
======END OF PAGE 215======
trading systems that may register as exchanges) be exempt from fair
representation requirements?
Question 51: Should all exchanges be required to comply with Section
6(b)(3) by having a board of directors that includes participant
representation?
Question 52: If not, are there alternative structures that would provide
independent, fair representation for all of an exchange's constituencies
(including the public)?
Question 53: Would the revised interpretation of "exchange" being
considered by the Commission adequately and clearly include alternative
trading systems that operate open limit order execution systems (even those
that also provide brokerage functions)?
Question 54: In light of the decreasing differentiation between market
maker quotes and customer orders in trading, should the Commission consider
an "order" to include any firm trading interest, including both limit
orders and market maker quotes?
Question 55: What should the Commission consider to be "material
conditions" under which participants entering orders may agree to the terms
of a trade? For example, should an alternative trading system be
considered to be setting "material conditions" when it standardizes the
material terms of instruments traded on the market, such as standardizing
option terms or requiring participants that display quotes to execute
orders for a minimum size or to give priority to certain types of orders?
Question 56: Is it appropriate for the Commission to consider the
activities described above as broker-dealer activities?
Question 57: How should a revised interpretation of exchange adequately
======END OF PAGE 216======
and clearly distinguish broker-dealer activities, such as block trading and
internal execution systems, from market activities?
Question 58: Are the distinctions discussed above accurate reflections of
exchange and broker-dealer activities? Are there other factors that may
better distinguish a broker-dealer from an exchange?
Question 59: How should a revised interpretation of the term "exchange"
adequately and clearly distinguish broker-dealer activities, such as block
trading and internal execution systems, from market activities?
Question 60: What factors should the Commission consider in determining
whether an organization of dealers is sufficiently "organized" to require
exchange registration?
Question 61: Does the revised interpretation of "exchange" described above
clearly exclude information vendors, bulletin boards, and other entities
whose activities are limited to the provision of trading information? How
should the Commission distinguish between information vendors, bulletin
boards, and exchanges?
Question 62: If the Commission expands its interpretation of "exchange,"
should the Commission exempt interdealer brokers that deal only in exempted
securities from the application of exchange registration and other
requirements?
Question 63: How could the Commission define interdealer brokers in a way
that would implement congressional intent not to regulate traditional
interdealer brokers as exchanges, without unintentionally exempting other
alternative trading systems operated by brokers?
Question 64: How could the Commission foster the continued trading of all
securities currently traded on alternative trading systems if these systems
======END OF PAGE 217======
are classified as exchanges under the interpretation described above and
some of these systems are required to register as national securities
exchanges? For example, what would be the effect on alternative trading
systems that wish to trade securities exempted from registration under Rule
144A if those systems are required to register as national securities
exchanges?
Question 65: How would the requirement to have rules in place for trading
unlisted securities affect the viability of alternative trading systems
that are required to register as national securities exchanges?
Question 66: Would the specifications in the OTC-UTP plan relating to the
trading of Nasdaq/NM securities pose particular problems for systems that
are required to register as national securities exchanges?
Question 67: Should the Commission extend UTP to securities other than NM
securities, such as Nasdaq SmallCap securities? What effect would an
inability to trade Nasdaq SmallCap and other non-Nasdaq/NM securities have
upon alternative trading systems that are required to register as national
securities exchanges?
Question 68: What effect would the prohibition on UTP trading of newly
listed stock until the day following an initial public offering have upon
systems that are required to register as national securities exchanges?
Question 69: How should existing exchange rules designed to limit members
from effecting OTC transactions in exchange-listed stock be applied, if the
Commission's interpretation of exchange were expanded to include
alternative trading systems and organized dealer markets? What customer
protection and competitive reasons might there be to preserve these rules
if alternative trading systems are classified as exchanges?
======END OF PAGE 218======
Question 70: What effects would linking alternative trading systems to NMS
mechanisms have on those systems? For example, how would such linkages
affect the ability of alternative trading systems to operate with trading
and fee structures that differ from those of existing exchanges or to alter
their structures? To what extent could revision of the NMS plans alleviate
these effects?
Question 71: Are there any insurmountable technical barriers to admission
of alternative trading systems into the CTA, CQS, OPRA, or OTC-UTP plans?
Question 72: What costs are associated with the admission of new
applicants to these plans?
Question 73: Are there any CTA, CQS, OPRA, or OTC-UTP plan rules that
would prevent newly registered national securities exchanges from obtaining
fair and equal representation on these entities?
Question 74: What effect would the admission of newly registered national
securities exchanges to the CTA, CQS, OPRA, and OTC-UTP plans have upon the
governance and administration of those plans?
Question 75: Do admissions fees for new participants required by the terms
of the plans present a barrier to admission to the plans? Do the plans'
provisions that all participants are eligible to share in the revenues
generated through the sale of data affect commenters' views on this issue?
Question 76: What effect would the admission of new, highly automated
participants have upon the operation of the ITS?
Question 77: How would compliance with the current ITS rules and policies
affect trading on alternative systems that may be regulated as exchanges?
How appropriate are these rules and policies for alternative trading
systems?
======END OF PAGE 219======
Question 78: What costs would be associated with newly registered
exchanges joining ITS? Would those costs represent a barrier for newly
registered exchanges to join ITS?
Question 79: Are there any ITS plan rules or practices that would prevent
newly registered national securities exchanges from obtaining fair and
equal representation on the ITS?
Question 80: What effect would the admission of newly registered national
securities exchanges to the ITS plan have upon the governance and
administration of the plan?
Question 81: What effect would the requirements to impose trading halts or
circuit breakers in some circumstances have upon alternative trading
systems if such systems were regulated as exchanges?
Question 82: What impact would registration of an alternative trading
system as an exchange have on the institutional participants of that
trading system, including registered investment companies?
Question 83: If the Commission allows institutions to effect transactions
on exchanges without the services of a broker, to what extent should an
exchange's obligations to surveil its market and enforce its rules and the
federal securities laws apply to such institutions?
Question 84: How could an exchange adequately supervise institutions that
effect transactions on an exchange without the services of a broker?
Question 85: What, if any, accommodations should be made with respect to
an exchange's surveillance, enforcement, and other SRO obligations with
respect to institutions that transact business on that exchange?
Question 86: How could institutions that directly access exchanges be
integrated into existing systems for clearance and settlement?
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Question 87: Under what conditions should an entity be subject to both
exchange and broker-dealer regulation?
Question 88: Should a dually registered entity be required to formally
separate its exchange operations from its broker-dealer operations (e.g.,
through use of separate subsidiaries)?
Question 89: Would this approach be an effective means of addressing the
issues raised by the growth alternative trading systems? What would be the
benefits of such an approach? What would be the drawbacks of such an
approach?
Question 90: Would it be feasible for the Commission to expand the scope
of rules eligible for expedited treatment pursuant to Section 19(b)(3)(A)
without jeopardizing the investor protection and market integrity benefits
of Commission oversight of exchange and other SRO rule changes? If so, to
what types of rule filings should immediate effectiveness, pursuant to
Section 19(b)(3)(A), be extended?
Question 91: If the Commission expands the scope of rule filings eligible
for treatment under Section 19(b)(3)(A) to include, for example, certain
types of new products, what conditions or representations should be
required of an SRO to ensure that the proposed rule change is eligible for
expedited treatment under Rule 19b-4?
Question 92: Should the Commission exempt markets' proposals to implement
new trading systems, separate from their primary trading operations, from
rule filing requirements? If so, should SROs be permitted to operate pilot
programs under such an exemption if they trade the same securities, operate
during the same hours, or utilize similar trading procedures as the SRO's
main trading system? Should there be a limit on the number of pilot
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programs an SRO can operate under an exemption at any one time? What other
conditions should apply to such exemption?
Question 93: Do differences between automated and non-automated trading
require materially different types or degrees of surveillance or
enforcement procedures?
Question 94: Which Exchange Act requirements applicable to registered
exchanges, if any, could be minimized or eliminated without jeopardizing
investor protection and market integrity?
Question 95: If an automated exchange contracts with another SRO to
perform its day-to-day enforcement and disciplinary activities, should this
affect the exchange's requirement to ensure fair representation of its
participants and the public in its governance?
Question 96: If an exchange contracts with another entity to perform its
oversight obligations, should that exchange continue to have responsibility
under the Exchange Act for ensuring that those obligations are adequately
fulfilled?
Question 97: What costs to investors and other market participants are
associated with the current regulation of alternative trading systems as
broker-dealers? Specifically, what costs are associated with the potential
denial of access by an alternative trading system?
Question 98: What costs are associated with each of the alternatives for
revising market regulation discussed above? For example, would either of
the two principal alternatives discussed in Section IV above impose costs
by limiting innovation? Would these costs be greater than those imposed by
the current regulatory approach?
Question 99: What regulatory costs can be shared by markets operating
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simultaneously as self-regulatory organizations, and what regulatory costs
must be borne by each market individually? What are the relative
magnitudes of these costs (as a proportion of total costs)?
Question 100: Are there innovations or adjustments that can be made to
market wide plans such as CQS, CTA and ITS that will lead to lower
regulatory costs for exchanges under any of the alternatives for regulating
domestic markets?
Question 101: Total regulatory costs vary with a variety of factors
(e.g., volume of trade, degree of technology applied in trade). Of these
factors, which are most relevant in considering the alternatives discussed
above? For example, recognizing that some market mechanisms may rely on
some factors more than others, to what extent are regulatory costs greater
for particular mechanisms than others?
Question 102: What costs are associated with the responsibilities of an
SRO? Will the costs to existing SROs be reduced by registering significant
alternative trading systems as exchanges?
Question 103: What regulatory burdens currently inhibit innovation of
trading systems? How will the alternatives discussed above change the
incentives for innovation?
Question 104: Will the alternatives discussed above impose costs on
systems that differ depending on the nature of the trade? For example,
will the proposed regulatory revisions change the costs of trades directly
between customers relative to the costs of trades between a customer and a
dealer?
Question 105: What regulatory approaches would best address the concerns
raised by the development of automated access to foreign markets? Would
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these approaches differ if U.S. investors accessed foreign markets in ways
other than those described above, such as through the Internet? Are there
any other alternative approaches that could be more appropriate?
Question 106: If the Commission were to rely solely on a foreign market's
primary regulator, how could it address the investor protection and
enforcement concerns discussed above?
Question 107: Should the Commission require foreign markets with only
limited activities in the United States to register as national securities
exchanges or obtain an exemption from such registration? How would this
affect U.S. persons trading directly on foreign markets?
Question 108: How can the Commission best achieve its goal of regulating
the U.S. activities of foreign markets? Commenters should take into
consideration that foreign markets are regulated abroad, that there is a
potential for international conflicts of law, and that the Commission has
jurisdictional limits. Given the difficulties of surveilling public
networks such as the Internet, would an access provider approach be
workable?
Question 109: What would be the best way for the Commission to regulate
the limited U.S. activities of foreign markets that provide remote access
to U.S. members?
Question 110: When should an entity be required to register with the
Commission as a non-exclusive SIP under Section 11A of the Exchange Act?
For example, should the activities described above require registration as
a SIP?
Question 111: If the SIP approach were adopted, is it likely that U.S.
members of foreign markets would wish to transmit their orders to such
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markets through more than one SIP registered with the Commission? If so,
should all but one of those SIPs be exempt from registration?
Question 112: Under the SIP approach, should foreign markets that allow
their U.S. members to transmit their orders solely through a registered SIP
have a safe harbor from registration as national securities exchanges?
Question 113: What type of activities should a registered SIP be permitted
to conduct on behalf of a foreign market without the SIP or the foreign
market registering as an exchange?
Question 114: What types of automated broker-dealer systems, both
operational and contemplated, would be encompassed within the above
description of access providers to foreign markets? How widespread are
these activities?
Question 115: Would the above description of broker-dealer access
providers adequately and clearly exclude traditional brokerage activities,
particularly handling the execution of customer orders on foreign markets?
If not, how should such activities be distinguished from traditional
brokerage activities, particularly traditional cross-border activities?
Should U.S. broker-dealers that provide investors with access to foreign
markets be subject to any additional requirements?
Question 116: Should foreign broker-dealers that provide U.S. investors
with automated access to foreign markets be required to register as broker-
dealers on the basis of that activity?
Question 117: What types of conditions, if any, should the Commission
place on access providers if it were to pursue that approach?
Question 118: If the Commission decides to regulate access providers to
foreign markets, what criteria should the Commission use in determining
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whether an exchange is a bona fide foreign market? Should a market be
required to have at least a majority of foreign members in order to be a
bona fide foreign market? Should the Commission exclude exchanges that
provide terminals in the United States?
Question 119: Should the Commission regulate as a U.S. exchange any market
that, although organized and having its principal place of business outside
of the United States, is under common control with or controlled by U.S.
persons, or whose decisions regarding trading rules, practices, or
procedures are made by U.S. persons?
Question 120: What factors should the Commission use in determining
whether an exchange is operating a trading facility in the United States
and is not a bona fide foreign market? If exchange-owned terminals are
located in the United States, should this constitute operating a trading
facility in the United States?
Question 121: What effect would a reinterpretation of the term "exchange"
under Section 3(a)(1) of the Exchange Act have on any Commission proposal
to regulate SIP and broker-dealer access providers?
Question 122: If the Commission decides to regulate access providers to
foreign markets, should the Commission require access providers to transmit
orders only to foreign markets that are willing to share, and capable of
sharing, information with the Commission in connection with investigations
involving violations of U.S. securities laws? If so, what standard should
the Commission use in determining whether a foreign market would provide
meaningful assistance to the Commission? If commenters believe that SIP
and/or broker-dealer access providers should be permitted to transmit
orders to any foreign market, indicate how the Commission could ensure that
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it has the ability to enforce the applicable provisions of the federal
securities laws.
Question 123: Should the Commission require access providers to transmit
orders only to foreign markets that are located in countries that have
entered into arrangements with the Commission to provide enforcement and
information sharing assistance?
Question 124: If the Commission regulated access providers through the
approach described above, should SIP access providers be limited to
providing their services to sophisticated institutions or should they be
allowed to provide any U.S. investor with the capability of directly
trading on foreign markets as members? If so, should broker-dealer access
providers be subject to similar requirements?
Question 125: If the Commission permits SIP access providers to offer
their services only to broker-dealers and certain sophisticated
institutions, how should this category of sophisticated institutions be
defined?
Question 126: Should the Commission permit SIP and broker-dealer access
providers to transmit orders to foreign markets for the securities of U.S.
issuers or only for the securities of non-U.S. issuers?
Question 127: Should the Commission limit the ability of SIP and broker-
dealer access providers to transmit orders to foreign markets for the
securities of non-U.S. issuers if the "principal market" for those
securities is located in the United States? If so, how should the
Commission determine when the "principal market" of a non-U.S. security is
located in the United States?
Question 128: If the Commission permits SIP and broker-dealer access
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providers to transmit orders to foreign markets only for securities of non-
U.S. issuers, how should the Commission distinguish between U.S. and non-
U.S. issuers?
Question 129: If the Commission decides to regulate access providers to
foreign markets, should they be required to make and keep records? What
records should registered SIP and broker-dealer access providers be
required to maintain?
Question 130: Should access providers be required to file periodic
reports? If so, what information should those contain?
Question 131: Should broker-dealer access providers be required to keep
records of denials of access to their services? Should they be required to
notify the Commission of such denials of access?
Question 132: What types of risks should be disclosed to users of SIP and
broker-dealer access providers? For example, should SIP and broker-dealer
access providers be required to disclose the listing and maintenance
standards of foreign markets to which they transmit orders on behalf of
U.S. persons? What would be the costs associated with such a requirement?
Question 133: Should access providers be required to make disclosures to
sophisticated institutions?
Question 134: What market information should SIP and broker-dealer access
providers be required to provide to the users of their services?
Question 135: Should direct trading in foreign listed companies be limited
to those that satisfy U.S. disclosure standards in order to better protect
U.S. investors?
Question 136: Is it sufficient to merely disclose to investors that the
information available about a foreign security may significantly differ
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from the information that would be available about U.S. securities? Do
public policy concerns dictate that the Commission make distinctions based
on whether investors receive adequate information?
Question 137: Are there circumstances under which unregistered foreign
securities should be permitted to trade on foreign markets through an
access provider? For example, should the Commission establish some de
minimis threshold for a foreign security based on the dollar value of the
U.S. float or trading volume in that security, or on the relative
percentage of U.S. float or trading volume compared to that of the home or
worldwide markets?
Question 138: Should the exemption from registration under Exchange Act
Rule 12g3-2(b) be available if a significant portion of an issuer's float
is traded in the United States?
Question 139: Given that broker-dealers currently trade unregistered
securities for customers, should the Commission reconsider its approach to
securities registration requirements in this context? Are there other
viable alternatives that would ensure adequate disclosure to U.S. investors
trading on foreign markets?
Question 140: Is trading in unregistered foreign securities through an
access provider to a foreign market appropriate if access is limited to
sophisticated investors? For example, should access providers be permitted
to transmit orders for unregistered foreign securities to a foreign market
on behalf of qualified institutional buyers as defined in Rule 144A of the
Securities Act?
Question 141: Are there uniform procedures that the Commission should
impose on foreign markets or on access providers to assure that securities
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are not sold to U.S. investors in circumstances that result in a public
distribution of securities in the United States that are not registered
under the Securities Act?
Question 142: What are the consequences to SEC reporting companies if
unregistered foreign securities listed on foreign markets are available to
be purchased or sold through access providers?
Question 143: Would any of the approaches described above provide an
effective means of addressing the issues raised by foreign market
activities in the United States, including providing key protections for
U.S. investors? What would be the benefits of each approach? What would
be the drawbacks of each approach?
By the Commission.
Jonathan G. Katz
Secretary
Dated: May 23, 1997
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